E121: How to Analyze Financial Risk

In this podcast episode, we discuss financial risk and the best way to analyze it. Most of us are aware that certain investments are riskier than others, but what do we mean when we say that? Are there different kinds of financial risks, and how do you know what types you should take?

Personal Financial Risk Analysis Topics Discussed:

  • Understanding how financial risk assessment is personal
  • What is risk at its root
  • Risk vs. Reward considerations
  • How to assess what risks exist
  • How to measure risk based on your needs and tolerance
  • Being aware of and guarding against cognitive bias

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Transcript: How to analyze financial risk

Nate: In this episode, we discuss financial risk. Most of us are aware that certain investments are more risky than others, but what do we mean when we say that? Are there different kinds of risks and how do you know what kinds of risks you should take? She’s Holly and she helps people find financial freedom.

Holly: He is Nate, he makes sense out of money. This is Dollars and Nonsense. If you follow the herd, you will be slaughtered.

Nate: All right, well, today we’ve got a topic to discuss, the topic of risk and it’s certainly something we’ve brought up in various ways before on our show. But we thought we would take a deep dive in just understanding what risk is. I feel like many of us hear terms whether it’s like, “Hey, the higher the risk, the higher the reward. The stock market is risky or we’ll hear things don’t take too much risk with your money.” And I get tired of hearing all of that being said because I don’t think we’re all talking about the same thing. And I don’t know if anybody actually is out there describing what exactly we mean when we say risks.

Holly: You’re right, Nate. We all have a concept or idea of what we believe risk is. But the reality is is that most of the time we don’t actually define what it is and that risk can be different for each person in different individuals. But the reality of it is in plain and simple terms in my viewpoint, risk is a lack of control.

Nate: Yeah, it is. I mean, when we talk about risk and we’ll talk about a few things and this is pretty unscripted as always for Holly and me, so we just kind of wanted to have an open-ended discussion for what is risk. What are the different kinds of risk someone can take? How does it work in your life? And so at what most people see as risk is the ability to lose money. And I think we may have talked about that before. We all know that certain investments carry risk. And I guess the default definition is, “Hey, we can put money in this thing and it could lose value and then I sell it sometime later and I will have lost money,” so that incorporates risk. And you hear something like, “Well, the higher the risk, the higher the reward.” And there is a trueness to that.

In other words, the lottery is a high risk high reward endeavor. So it certainly is true that the higher, the risk, the higher the potential reward, but it’s not in a vacuum. Unlike the lottery where we all know there’s a lot of risks that you will not get back what you put in, that the majority are losers and there’s only one winner practically. People say that about the stock market, about mutual funds. They’re like, “Well, it’s a little risky, but hey, the more risk more reward.” But that’s a foolish way to live life. What do we mean by risk? What do we mean?

We know what the risk is in the lottery. We know that, “Hey, I’m going to buy this lottery ticket. And the chances that it gets pulled later, the chances these are the winning numbers” it’s honestly really slim, but there’s a small hope it’s going to pan out. That type of risk is a little bit different honestly than stock market. I understand that. I’m not trying to equate the two, but all that to say higher risk does not mean higher reward at all times. So I thought maybe we could start off by what most of the American population, their level of risk financially is tied mostly into their investments that they’ve made in the stock market, whether it’s through their retirement programs or just brokerage accounts. Most of us would associate that’s our main risk for most Americans.

So I guess I thought we could maybe discuss for a moment what is the actual risk in the stock market and why is it risky? Maybe a little bit deeper than just the typical like, “Hey, we could lose value.” We know it can lose value, but what does that mean to us? How is this risky? How can I measure this risk? What risk am I actually taking?

Holly: Well, I think, Nate, the biggest thing is exactly what you said. Most of us when we view the stock market or our retirement programs that are tied to the stock market or that it’s the risk is prices go up and down, but that’s not the real risk. The real risk is how much money will be there in the future when you go to retire and how much time do you have if you have less money than when you put it in there? Do you have to accumulate even more money? I mean, eventually it will always come back most of the time, right? But-

Nate: And we have yet to experience, I think you’re right, a time where we had a market crash that had not rebounded. It just depends on how long it’s going to take, right?

Holly: Right.

Nate: And-

Holly: And so that rebounds that big phase. I mean, there’s some people I know that, hey, they did really, really good and if they retired maybe in 2007, they had a really good retirement portfolio if you know what I mean.

Nate: Exactly. Right. That’s a good point. And that’s what bothers me a lot of the time when people would say to me, especially when they may be comparing it to infinite banking or they bring up the fact that their stock market investments are doing really well. The valuation of our assets at a single moment really doesn’t mean anything because it’s not real money. It’s just what other people are willing to trade for that stock. You know what I mean? It has nothing to do with any real money. So they’ll say, “Well, buy stocks did great this year.” I’m like, “Congratulations.”

But we all know that the stocks are volatile. And so the risk is exactly what Holly was implying and this is what we wanted to get across. The truth is no matter what we want to say, the truth is we’ve never seen the stock market go to zero. I guess it could at some point the S&P 500 could lose all of its value. I don’t know. That would be kind of an apocalyptic scenario, but all that to say we do know the stocks rise and fall. Most of the time it goes up and then it goes down, it goes up, it goes down. But over the trajectory of time, it has gone up.

So most people their answer, “Well, yeah, stocks, they go up and they go down. It’s volatile. It’s a little risky, but it goes up over time. It always has. You just need to wait it out. You just need to wait.” If you lose some money, it’s okay. Just stick with it, it’ll rebound. It’ll catch back up. And for the most part, that’s true actually. I’m not even here to discredit that, for the most part that’s true. The risk that you’re taking when you invest money in a volatile asset like that is it is true.

It’s not the fact that it’s going to go to zero at some point. That’s unlikely. Maybe if you bought one company, that’s why a mutual fund exists, it’s to spread out the risk. If you bought only Exxon, I mean, Enron, excuse me. Then yeah, you would have lost all your money it would have went to zero. That’s why you don’t put all your money in Enron. It’s not the best bet. All that to say, where I’m heading with this is that the timing is extremely important because it’s true that if you buy in in a retirement program and it’s going up and down over your lifetime, it will probably go on an ever upward trajectory.

The problem though is that the risk you’re assuming is that you don’t know how much it’s going to be worth when you need it. That is the risk. The risk is I don’t know what it’s going to be, how much it’s going to be worth when I need it. It could be worth way more than I paid. It could be less than I paid. We know that it’s going up over time, but as Holly if you said someone who wanted to retire in 2008, it was a risky time to retire. Why? Because they would have just lost all the money they put in, 50% of it gone, which means the balance of their accounts was probably less than what they had put in over time. Which means that if they needed to start selling assets to produce income, then suddenly they could be selling assets at a loss and therein lies the risk.

We know that they can rebound. The question is do you have time? Do you have time to let it? You’re going to need it someday. Do you have time? In other words, some assets produce actual income. Others, you have to sell the asset to receive money to live on. So there’s two different ways to do it. If you buy a rental property, you can hold the rental property. It doesn’t really matter what the valuation is going around as long as you can rent it and you get cashflow, that’s fine. You need the cashflow to live on. With a stock, you have to sell the stock to get money to live on. You have to create income by selling assets. And so it’s less risky as you’re building it.

But once you have to stop building it and start pulling from it, that’s where you see very clearly the risk you’ve chosen to take, which is I don’t know what these are going to be valued at. I don’t know what they’re going to be valued at 10 years from now. Back when I was building up well for those previous 40 years, it didn’t seem to bother me. The volatility I can handle. But now that I’m here, man, I don’t know when I should sell, when I should buy, when I should stay.

If you ask a 65-year-old and let’s say you’re 35 and you’re listening to this and you ask a 65-year-old, “What’s the risk of being in the stock market?” They’d say, “Well, maybe at 35, you didn’t see it.” But now you built up your assets, it’s all on mutual funds, and now you’re 65 and you definitely see the volatility as something that is terrifying to someone who actually now needs the money. So that’s the most common form of risk for most people is the volatility of future prices. You can stomach them while you’re building, but essentially the risk is what is the price going to be when I actually need the money?

Holly: Even the reality of the fact that you might’ve lost in 2008 or ’09, several people that have the timing and then to rebuild. How long does it take to rebuild? But right when they were just about at that point and I know an individual, this is his third rebuild. He just gotten almost to where he was at in 2008 and ’09 and all back to where he was at in 2008 all over again. And it’s how much time do you, like you said, ask yourself, “How much time are you going to have to rebuild that wealth or to make it?” If you get there and you don’t get out soon enough because we don’t know when it’s going to fall or not, then you have zero again. And maybe you don’t have the 10 or 15 years it’s going to take to rebuild. [crosstalk 00:10:23] build the wealth.

Nate: Right. It could take that long to get it back depending on [inaudible 00:10:24]. I mean, that’s the thing. What I’ve always said and you don’t hear this for anybody but us. So it’s key. That’s why we’re here, but you always hear, “Well, the stock market goes up over time.” No, no. At the end of the day, whenever you’re building your wealth in the typical American way through retirement programs and mutual funds, the same principles always apply. And the principle is timing is everything. When you get in and when you get out. That is everything. That is it. It is not it goes up over time by itself because that implies that you’re in it forever. And so it’s just always going to go forever.

But in distinct snapshots, that’s not the case. Over a distinct 30-year period from one 30-year period to the next 30-year period, the chances that it goes up are slim on average. But in reality, you could be right where you were 30 years ago if you’re 30 was a big crash. So at the end of the day, anytime that you’re dealing with a valuation of an asset as your primary wealth building return, it is going to be when you got in and when you got out. You can talk to people with Bitcoin is when you get in, when you get out. That’s fundamental. There’s winners and there’s losers in the stock market, and it’s hard to be a winner.

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Nate: There’s also different kinds of risks [crosstalk 00:13:09]. It’s not all the same. So with the stock market, you have this risk of timing. You have this risk of volatility of future values. And the fact that the real key to success is timing in the market. And some people would say, “Well, Nate, it’s not timing the market. It’s time in the market.” No, that’s not true. Timing is everything. Now, the amount of time you spend in the market may work in your favor, but on the flip side, try selling in 2008, 2009. It probably didn’t matter how long you’d spent in the market trying to retire and sell some assets to produce income, you’re probably going to be at a loss.

So timing is everything in there, but not every asset has that kind of risk, small business ventures and different things like that. And if you’re going to open up a small business that costs money that you’re going to have to put in, that’s a completely different kind of risk. And that goes back to the saying though that the higher the risk, the higher potential reward. In other words, if I go invest in a small business that’s trying to get off the ground, I can make me a ton of money and I could lose everything. And it’s all tied to that one, small business. That’s high level of risk, but it’s completely different than the timing aspect.

It’s essentially will this venture fail or will it survive and succeed? It’s just got two choices, two options. Either it’s going to survive or it’s going to fail. It’s probably not really the same type of risk as it is with the S&P 500. So there’s different kinds of risks that would lead us to, Holly, what kind of risks should we even take?

Holly: I say you take risks really when it’s opportunities that you know something about and you’ve actually learned or grown or done some research in versus something you know nothing about. And Nate, we talked about this, but in all honesty, I would never go in buy rental property for myself or apartments or something like that, and then go and rent them out. I know nothing about real estate really in regards to the rental income and how it works. I would have to hire somebody to manage or do that.

But if you are good at flipping houses or a lot about the real estate market and the ups and downs and the ins and outs, it can be a great investment for you or risk you want to take because you know what is happening and taking place versus somebody that knows nothing about it. And they’re trying to get successful flipping houses, for example. When they don’t even know what it means to flip a house.

Nate: That’s a good point. That goes back to our kind of initial definition of what is risk? Risk is lack of control. There’s very few things you’re going to control, so most things have some sort of risk involved. We understand that, but how to make something less risky is to increase the amount of control you have over that. And how do you increase your control of success? Your own knowledge. So we’ve always said there’s really not a good investment in a bad investment. There’s simply good investors and bad investors. That’s the way the world works.

The stock market is not a good investment for everybody. It’s a good investment for Warren Buffett. He understands it way better than I do. He’s built his life around it. But for the average Joe in his underwear in front of the computer buying GameStop stock at 4.50 being a part of the movement, he lost a lot of money. There’s good investors and there’s bad investors, more so then there’s good investments and bad investments. The same thing goes with risk. There’s good risk and there’s bad risk. How do you tell the difference? Your own understanding of what you’re getting into. That will determine whether it’s a good risk for you to get involved in or a bad risk to get involved in.

So what kind of risk should you take? I am of the opinion that you should be mainly taking risks in things, first off, that you have a passion for. I believe that’s always fundamentally important. I know a lot of people who are passionate about cryptocurrency. They’re the ones who should be in cryptocurrency. Other people who just want to make a quick buck, you’re going to lose. You don’t understand it. You haven’t taken the time. You’re not passionate about it. Just stay clear.

Don’t let the fear of missing out dominate you. It’s okay to miss out. Let the people who have studied it and understand it and love it, let them be the ones to pour money into it. Not the guy who’s hoping for a quick buck. Almost every story of someone losing a ton of money was them investing in something to gain a return that they were pitched, though they have no say in it. They don’t even fully understand it. Somebody told them about it. They hear it on the news and they’re like, “I’m going to go ahead and buy in it.” And they’re the ones that lose money.

So I guess what kind of risk should you take? It’s ones that you can calculate yourself. It’s a calculated risk. It’s something that you understand what the risk is and you have decided that the risk, the possible risk of whether it’s losing or the timing of it, whatever it is that you think of now based on your own expertise is a good time to hop in. Like Holly, we were talking about this before the show. A dentist who wants to go open up a new practice or purchase an existing practice. That is a different kind of risk. That’s a good risk. Why? It’s not because pouring a ton of money into a small business is for everybody. But if this guy has already built one successful practice and he understands how to build a practice, it seems like it’s a good risk for him to assume that he can figure out how to make this other practice successful.

But it wouldn’t make sense for Nate Scott who is not in the world of dentistry, has no idea how to make it profitable for me to say, “You know what? I heard this other guy was successful when he bought this dental practice. I think I should go try to find a dental practice to buy.” That would just be stupid, but that’s essentially what we do. Maybe not in that exaggerated form, but that’s essentially what we do with many of us with a lot of investments. We hear something is a good place for money, so we say, “Okay, I’ll throw money in it.” It’s completely uncalculated and many times we don’t even understand what the risk really is or what it’s going to take to be successful.

Holly: I get pitched a lot of investments every week. “Hey, you should really do this. Hey, you should really do that.” Nine times out of 10 and sometimes 10 out of 10 of every investment on pitch I don’t do it. Number one, because I’m not passionate about it. I don’t care. Like stock, I just don’t care to look at stock markets up and down and this and that. So I’m just not going to do it. But there’s other ones that when you’re passionate about, or it piques your interest and you can do a little research and you know what risk you’re taking and it’s calculated like you said, the control. It’s not even as much it’s the control and the fact of, if it does go south, what did it cost me? What did the reality of that cost me and am I able to recapture that or get that money back in another way if it went to zero? Like we say with the stock market, that wouldn’t happen.

But if I lost it all, how long is it going to take it to recover? I think that’s the other question you need to be asking yourself is not just are you passionate about it, do you know something about it. But if it does go south, what is that risk look like for you realistically?

Nate: Yeah, that’s a good point.

Holly: And how do you actually get that money back that you lost or how long will it take to get it back? Because those are questions we don’t often think about. I hear, “Oh, we lost all the money.” And I’m like, “Okay, well, how long did it take you to build it? But also how long do you think it realistically is going to take you to get it back?” And it really does depend on how you chose to invest the money in what vehicle you used to put the money in there.

Nate: That’s true, yeah. And so everyone has their own tolerance for risk to some degree. The entrepreneurial mentality, they may be more willing to go find some things that are kind of on the fringe. I’ve heard many of horror stories being in the financial industry and having a lot of clients. I’ve had some, as Holly said, pitched me some opportunities. And one time I remember getting pitched an opportunity. This guy saying you make 12, 13, 14% in this fund of sorts. But the more I learned about it, the more I realized this risk that I would take by messing in it it’s just not worth the reward. And there’s so many things that could happen that could make this venture unprofitable and fail. And then about a year later, that’s exactly what happened. It failed and now going through bankruptcy courts and everything’s trying to get back as much money out of this business as they can.

That’s more common than what we’d like, especially when you’re trying to invest in something that is more fringy. Profit is there, but also the risk of losing a lot more money is there and you need to understand that and calculate it. As Holly said, you need to make sure that you are set up in a way that it makes sense to take that risk. So what kind of risks should you take? My opinion is try to take as little risk as possible. Well, how do you take as little risk as possible? You learn about whatever it is you’re trying to get into and you learn what it takes to be successful there.

If you want to get into real estate, don’t just buy the first property that you see on Zillow in your price range. Think like a business owner and get into the right opportunities. So the goal of business is to make as much profit as you possibly can with as little risk as you possibly can. That’s the definition. Now risk as we said to one person is different than risk to another person. So you need to become good at something and thus reduce the risk of failure because you actually have learned something of value. You are always your best investment.

And maybe as we wrap this up, Holly, we could kind of transition to how the infinite banking concept has helped you and me understand risk and risk/reward ratios. Maybe it’s better so than what we would’ve been able to understand it prior to our understanding of infinite banking just in general how its shined a light and maybe helped us see some things about risks that we may have just left uncovered.

Holly: I think one of the main things for me, Nate, and we kind of talked about this a little bit to you and I is it does allow me in some ways to be more selective with my risk. When I’ve put it into a policy and I’m taking that money out as an investment, I feel like I’m able to be more selective, number one with the risk. But it also allows me that even if I take that money out, I’m technically not losing the interest that money is generating in the policy. So I’m still able to make money and still be able to invest it.

So for me, I feel like I have more freedom to be selective, but I also can truly calculate to an extent the risk I’m taking and how long it’s going to take me to gain that money back if it goes south. Just by using a policy, I’m able to literally calculate this is how many years if this goes completely south, it’s going to take me to recapture, regenerate that money if you want to say gain the money back to an extent. Yes, it’s future. It’s not worth as much in the future, but I really didn’t lose anything because it continued to grow.

Nate: Yeah, I definitely agree that the fact that you can make so much with no risk inside of these policies, the fact that they’re guaranteed to grow each and every year, it really does put you in a position of being able to be far more selective. Because I feel like for the general population you’ll look at 10-year US treasuries and you’ll look at municipal bonds and you look at cash and savings and CD rates and you looked at all these things and you just can’t make any money. And so most people feel like the only thing they can do is go take risks, go dump it into the stock market or find something else to put money in. Because the typical low risk guaranteed to increase ventures are just not paying out very well, which makes mutual dividend paying whole life insurance sign like a knight in shining armor type of thing, the light on the hill like hey, there is still a way to make money with no risk and have it be very profitable for you, tax-free inside of these policies.

But also you never have to worry about volatility. So in the bond market with interest rates moving around, the value that you could sell your bond for is actually always changing. So even though you may put money into the bond market to earn a less risky return you could say. If interest rates were to jump up, all your low interest rate bond holdings would not be very valuable anymore. You’d have to sell them at a loss, but that type of environment doesn’t exist for the policy. So you are guaranteed to increase every single year, no matter what’s happening outside. And we can access the money to be selective with what risk we want to take.

If we want to start a new business, that’s great. If we want to invest in real estate, that’s great. If we want to expand on the house and increase the value there, that’s great. We have far more ability to be selective with risk as opposed to the conventional thinking, which is just throw all your money in retirement programs. Then you are accepting systemic risk as your hope and you cannot be selective at all. If all your money’s in a 401(k) or IRA, you’ll be very limited on what you can buy. It’ll be mainly in the world of the stock market and you cannot be very selective with it. And if you sell out of the stock market, you would have no way to make any money.

So I have certainly seen that with IBC. Not only has it allowed me to be more selective, but it has allowed me to be more profitable really no matter what I do. And we love that that’s the basis for our wealth building journey is that, “Hey, no matter what I do, I’m going to be successful and I’m only going to take advantage of opportunities that have a high likelihood of accelerating my success.” And I don’t have to take systemic risks as the norm.

Holly: Yeah, there’s a lot more peace even when there is a risk in the investment by being able to be using IBC to make that investment than there ever was before. Like the fear of if this goes south, what are we going to do? Doesn’t control so much the decisions. And to be honest, it’s actually head thinking or head knowledge or your education like we say. Ask lots of questions, educate yourself versus making a decision based on emotion.

Nate: That’s a good point. Yeah.

Holly: And I think when your money is still growing for you and there’s a security in that at least or in the ability to make your dollar do more than one thing, it truly isn’t a decision of the risks that you’re taking is made not with an emotional decision, but really with an educated calculated risk of what does this mean? From a lot of us because if we lose it all, like you said, that systemic risk. If we lose it in the stock market or in the mutual funds or the bonds we can’t sell or whatever it may be, you start making decisions emotionally because you’re just trying to get that money back as quick as possible.

Nate: Yeah, I do think it can help avoid emotional decisions financially, which are always the worst kind and you’re right. Knowledge that, hey, if I have built up equity in this policy and I borrowed against it to make this investment knowing that the cash value and the death benefit in that policy are still maintained, it’s still a benefit of the family. That does help ease the loss if something does go south in the investment. It’s not like I just lost the money and it’s gone forever, and there’s nothing I can do about it. At least I have something still to show for it. So that’s a great thing to point out.

I think we can keep going, but what we want to get across is that most things in this life have some form of risk. There are things you can do to reduce your risk and still be very profitable mainly by improving yourself and understanding yourself and what you are good at, what you’re bad at, what are your strengths and focusing on areas that you can use your strengths to control more of the outcome. Because for the most part, risk is a lack of control. You don’t have control of the outcome. You’re hoping it turns out good. It may not.

You want to try to control as much of the outcome as you can knowing that you can’t be in control of everything, but you’d like to invest in things and take risks that you have more of a say in what the outcome is going to be, and that you’re good at it. And that could be the case with stock market investing as well, become good at doing that as well. Understanding what the risk is of whatever it is you’re trying to get into is important as well. So understanding what is the real risk of the stock market? If it is to go up over time as history has shown, what risk am I really taking? And that is the volatility of future valuations.

And that there will be a time when you don’t have time on your side. And then whatever the valuations are at that point is going to become very crucial. So it can make a lot of sense to build a large portion of your wealth not stuck in a volatile place. Something that’s more assured of success and something that you can control more of. I think that’s a pretty good summation. Anything last before we close it out for you, Holly?

Holly: No, you said it perfectly.

Nate: All right. Well, thanks for joining us again. This has been Dollars and Nonsense. If you follow the herd, you will get slaughtered

Holly: For free transcripts and resources, please visit livingwealth.com/e121

Announcer: Dollars and Nonsense Podcast listeners, one more thing before you go. Ease your worry and start your journey towards security today. Visit livingwealth.com/secretbanking. You’ll gain instant free access to this special one-hour course Holly and Nate made for you. Again, that’s livingwealth.com/secretbanking.