In meetings, clients often lead with the question of whether their investment portfolios need adjustments. Given our consistent emphasis on the importance of comprehensive financial planning over investment management alone, that always surprises us. We believe the constant news cycle and the financial industry’s marketing efforts drive this focus, making investments seem central to financial planning.
While effective portfolio management is important, it’s just one piece of the bigger financial picture—and a relatively straightforward one to manage. Life is complex, and many financial risks deserve attention. To us, focusing primarily on portfolio construction is like playing checkers; we prefer to play chess. Instead, our conversations should result in long-term, goal-oriented, and plan-driven actions. An uncomplicated way to think about it is:
Goals → Plan → Portfolio
Our role is to help you develop a financial plan that comprehensively addresses the risks to your financial well-being, centering our actions on things we can control. That includes helping you plan for and navigate inevitable downturns in your portfolio without making behavioral mistakes. The following sections provide a pragmatic perspective on financial risk and how you might improve your long-term outcomes. After that, we delve into the reality of investment risk and the industry’s role in inflating your concerns.
Understanding Financial Risk
To illustrate our point, we listed risks that could affect your ability to reach your financial goals and then organized them based on how likely they are to affect you and how much damage will occur if they do. Below is an example based on risks that apply to everyone.
As you can see, portfolio volatility and tax policy fall in the high-probability, low-damage quadrant. Although these things feel scary in the short term, they are inevitable and, in the case of volatility, necessary for long-term growth (more below). They are simple to manage with the right mindset and planning.
The items in the high damage, low probability quadrant (disability and early death) are serious but also navigable with proper insurance planning. Once the appropriate measures are in place, those items can shift into the low probability, low damage quadrant.
The items in the high-probably, high-risk quadrant are the most concerning. They are likely to occur and can cause a plan to fail. However, since they won’t happen for a long time, it is easy to delay addressing them, especially when distracted by things that seem more urgent, like news headlines impacting short-term market movements.
The point is that we think people spend too much time worrying about things they can’t or shouldn’t change, like the items on the top left, and too little time (and money) protecting themselves from things that could do real damage (the items on the right).
As financial planners, it’s our job to help clients manage the right risks at the right time. Meanwhile, the financial industry spends much time and energy dwelling on investment risk. That manifests in endless market commentary, strategy missives, and communications about the worry du jour. And there has been a proliferation of financial products specifically designed to minimize volatility. No wonder you worry about your investments, but let’s look at what is really going on.
Types of Risk Explained (Optional Reading)
Expand the sections below to learn more about the types of financial risks and our rationale behind placing them in each quadrant.
Inflation Risk
Inflation is inevitable, with 2% being the target. However, as we have seen over the last few years, it can be much higher and incredibly damaging. At a 2% inflation rate, costs double approximately every 36 years. If the inflation rate increases to 3%, costs double every 24 years. And a 5% inflation rate doubles costs roughly every 14.5 years. The key to managing inflation is to build a sizable nest egg and then stay invested so that your growth rate will outpace inflation. This approach isn’t guaranteed since we can’t predict the future, but over long periods of time, it has a strong probability of succeeding.
Another challenge is that inflation affects people differently, depending on their life stage and the type of inflation. For example, older people typically consume more healthcare than younger people, and healthcare costs tend to rise quicker than “overall” inflation. Therefore, we like to model the potential impact of various inflation scenarios on our client’s plans.
Healthcare
Everyone will incur healthcare costs at one point or another. According to the Fidelity 2023 Retiree Health Care Cost Estimate, a 65-year-old couple can expect approximately $315,000 in lifetime out-of-pocket health care expenses. That includes copayments, deductibles, Medicare Part B & D premiums, and prescription drug costs.
Longevity
The average life expectancy is nearly 75 years for men and just over 80 years for women. However, planning for average is typically not a prudent strategy. People consistently underestimate their longevity, and those with more financial means tend to live longer. Therefore, like inflation and health care, longevity is likely and could be devastating if you don’t plan. That’s why we recommend investing and spending strategies that are likely to survive the impacts of inflation over your lifetime, whatever that may be.
Long-term Care Costs
The potential for needing long-term care at some point in your life is very high. About seventy percent of those turning 65 will need it. And, it’s expensive! Long-term care can range from several thousand dollars a month to over $100k annually, so building this risk into your plans through additional savings or insurance is essential.
Portfolio Volatility
Occasional losses in your portfolio are inevitable and sometimes dramatic. Behavioral finance theory says that humans suffer from loss aversion. The emotional pain of a loss is twice the emotional pleasure of an equal gain. So, it should come as no surprise that there has been a proliferation of financial products designed to allow for upside market participation with some component of downside protection. In our view, adding these types of investments does not typically improve overall investor outcomes.
Taxes or Tax Policy Change
Tax rates will change over time, and you can do little to affect that. However, you can potentially take steps today to minimize your lifetime tax burden and protect yourself in the future, so we put this risk in the high probability but low damage quadrant.
Pre-retirement strategies may include reviewing pre-tax versus post-tax contributions to retirement plans, backdoor Roths, and Roth conversions. Post-retirement planning may involve managing your tax bracket with distributions from various account types and utilizing strategies such as Roth conversions or Qualified Charitable Distributions (QCDs). That can reduce total taxes and potentially prevent Medicare premium surcharges.
Disability or Premature Death
Most people wouldn’t dream of going without home or car insurance. Yet many forgo disability and life insurance. We find that curious because disability or death negatively impacts cash flow and could potentially be even more devastating than damage to your home or car. It could affect you or your loved one’s ability to meet expenses and save for the future.
People may avoid this topic because it is hard to plan for and unpleasant to think about, yet it can occur at any age. Indeed, one in four 20-year-olds will become disabled before they retire. Therefore, it is crucial to assess your financial exposure in the event of death or disability. Your employer benefit plan may even offer inexpensive, easy-to-obtain life and disability coverage.
Understanding Investment Risk
Typically, when investors speak about risk, they are referring to the potential for their investments to decline in value and envision that as a permanent impairment of their portfolio. However, investment risk is more than the possibility of losing money. It is about the fluctuation in value that occurs for an individual security or portfolio around the expected return, both to the downside and upside. This fluctuation is known as volatility.
Consider this simple chart:
What we can infer from this illustration is:
The expected downside will disappear if you remove all expected risk (volatility) from your portfolio. The problem is, so will the expected upside.
Therefore, risk (volatility) is mandatory for growth.
That means it is likely that the key to achieving positive long-term investment results is not to limit volatility but to embrace it.
How Does the Financial Industry Mislead Us?
The financial industry talks about volatility as if it is assumed that our goal is to avoid it. That is because fear-mongering is how the financial industry sells its products. As humans with strong protective biological instincts, we are easy prey for financial product marketers. You’d be shocked at how often we are pitched products (to sell to our clients) built to limit volatility.
Downside market volatility is scary and feels like a threat (we’ve yet to see someone threatened by upside volatility).
We instinctively respond to perceived threats in life, which serves us in many ways. If we are cold, we put on a jacket. If we touch something hot, we pull our hand away. These instincts are helpful because they protect us and keep us alive so that we may perpetuate the species. However, these instincts have yet to evolve in helpful ways for investing. Quick reactions when investing often hurt our long-term financial health. That’s a big reason why, according to the 2023 DALBAR Quantitative Analysis of Investor Behavior, average equity fund investors don’t perform as well as the S&P 500 index.
The average equity fund investor typically engages in bad behavior, like market timing, which can hurt you in the long run. Yet, thinking 20, 30, or even 40 years into the future about far-off things like retirement or inflation is hard for us – it’s too intangible. And if you think about it, that makes sense. Worrying about inflation, volatility, or concerns surrounding a long-term retirement are relatively new human issues. Our brains haven’t evolved yet to process this intuitively.
Therefore, we think developing a different perspective on risk (volatility) is essential. Volatility will always be present in investing, and it will only seem scarier as you age and become more vulnerable (and wealthy). Embracing volatility as an ordinary and necessary part of stock market investing and taking the appropriate steps to protect yourself can prevent you from overreacting and damaging your financial future.
The Bottom Line
Stock market investing is not a complex game that only experts can win. With the right approach, investing in the stock market can be pretty simple. In our view, the right approach is as follows:
Goals → Plan → Portfolio
Therefore, portfolio construction is a straightforward process of investing in a diverse set of assets that are likely to earn the returns needed to accomplish your goals.
The financial services industry leads us to believe that portfolio construction and management are where we must spend most of our time. However, through experience, we have learned that once you establish a plan and portfolio, the complicated side of investing is not in the build-out but in the operations. We’ve often said, “Along with a prospectus, investments should come with an owner’s manual.”
The reason behind that is investors are people, and people feel emotions. The most prominent emotions in investing are fear and greed. An example of greed might be investing heavily in tech stocks, thinking they can only go up. Fear could manifest in the desire to sell long-term assets when current events lead us to believe we are doomed.
To justify their services, financial salespeople often exploit investors’ fears of investment risk by selling products marketed as “low volatility,” “private,” or “alternative.” At Golden Road Advisors, we are adamantly opposed to that approach. Instead, we focus on a comprehensive planning process designed to enhance the probability of excellent financial outcomes by addressing the risks that really matter. We encourage you to reach out to discuss how we can help you.
Editors Note: To hear Kevin Caldwell expand on this concept, please watch the video below.
