How Do You Handle Risks?
Life is full of risk. There is intentional risk, unintentional risk, and unexpected risk. Intentional risk is going to a country that hates Christians and telling them about Jesus. If you are caught, it is fairly certain that the consequences will be painful or even disastrous. Unintentional risk is what we do every day from the moment we wake up until we pillow our heads in the evening. When I get in our Ford Escape and drive somewhere, I am taking a risk. I’m not intending to be involved in an accident, but it could happen. The crash might be unintentional because the other driver did not see me or because I misjudged something on the road.
Unexpected risk is a threat to our wellbeing that came in a way we could not see. Every time I go into a place where there are other people, I run the risk of catching Covid-19, the flu, or some other nasty bug that will put me in bed. Everything looks safe and normal, but then the unexpected, invisible virus invades and creates detours and delays.
Some spend their lives in constant worry and avoidance with all kinds of risks. I think of the character Adrian Monk. His life view is constantly in a state of fear of risk or bad consequences. In Season One, Mr. Monk and the Psychic, Adrian says, “You’ve got to be a little skeptical, Sharona. Otherwise you end up in believing in everything – UFOs, elves, income tax rebates.” In another episode Sharona asks, “How does it feel, always being right?” He responds, “Terrible.” Another time he said, “Be careful. There’s a lot of gravity out there.” Still another, “I don’t mind change. I just don’t want to be there when it happens.” In Monk’s view, fear and worry dictate most of life’s decisions. It doesn’t have to be that way.
Types of Risk
I divide risk into three categories when I buy an investment. The vast majority of our investments fit in risk category number three. First, it is helpful to remember that market volatility is not risky for the long-term investor with one exception. If you don’t have sufficient cash to weather the market temper tantrums, then you are running a risk that is irrational. Cash is no fun, but a certain amount of cash prevents foolish or unnecessary selling of quality investments.
Risk Category One is Crazy Risk
There are many investments, for the short-term or the long-term, that are irrational when I look at the value proposition. These investments are more like Las Vegas than like a property on a Wisconsin lake. Las Vegas is an almost certain way to lose your money. Lake property may take years to appreciate in value, but it will appreciate in value.
Sometimes investors, me included, buy an investment and things change in such a way that the future now looks grim. Most investors just want to “break even” and so they hold onto a capsized investment until it sinks to the bottom. While I strongly dislike sell limit orders, I watch our positions and look for warning signs. One of the warning signs that usually causes me to exit is a dividend suspension or cut. I’d say I sell at least 90% of the time when that happens. Thankfully, that is a rare event. When a dividend is cut, you have a warning sign of crazy risk.
Risk Category Two is Short-term Risk
Short-term risk where I might make an easy 10-25% but am willing to suffer a loss. This is a relatively small portion of our total investment strategy. Usually I also trade covered calls on this type of risk, which reduces my overall cost. For example, I have been trading Tesla shares this year. TSLA does not pay a dividend and it is a higher risk investment. However, because I can trade covered calls on my shares, I have been able to make $8,405 in options income. This does not reduce the risk, but YTD I am in positive territory with my Tesla investment. This risk is only a bit more than one percent of our total invested capital, so it isn’t a risk of any significance in the bigger picture.
Risk Category Three is a Forced Sale
Short-term volatility that may impact the flow of income needed. In other words, do I have to sell something at an inopportune time to get some cash? If so, then I have risk. However, if I can live on my income from Social Security, dividend income and whatever I generate using covered call options and cash covered put options, then the risk as less daunting. That is why we have a dividend growth strategy, and I can afford, starting next year, to take my RMD without selling any investments.
The current price of a share of any investment is a risk only if I have to sell. If the investment is paying a dividend, I can either use the dollars, give them away, or reinvest in more shares of some other investment. A lower price is often my best friend when you think long-term.
Other Unexpected Risks
There are certainly other types of unexpected risk, including living too long and having $0 left, government tampering and changes to the legal landscape, interest rate risk, inflation-related risk, competition risks, etc. But I don’t spend my days worried about those things. I cannot control them. I focus on the decisions I can make that keep long-term risk to the minimum. If unexpected risks make you freeze like Monk or repeatedly ask for a “wipe”, then you are not thinking in a rational manner.
Spending Too Much Risk
One thing citizens in developed countries do is spend too much. A recent Barron’s article by Elizabeth O’Brien explained this with a helpful piece titled, “The Reverse 4% Rule Puts Retirement Income, Spending Into Perspective.”
She started by reminding her readers of the common four percent rule. “You’ve probably heard of the 4% rule, which says you can withdraw 4% from your nest egg each year in retirement, adjusted for inflation, and not run out of money for at least 30 years. While experts love to debate the particulars, it’s still a good starting point for estimating how much you can afford to withdraw on an annual basis.”
Then she shared a helpful example to illustrate the reverse rule. “Flip it around, and it’s also a handy way to gauge the impact of financial decisions. Here’s how the ‘reverse 4% rule’ works: Divide your withdrawals or contributions by 4% and you’ll get a sense of how much a specific financial decision can affect your future retirement lifestyle and security. For example, say you’re debating between buying a used car at $25,000 and a new SUV at $60,000. The extra $35,000 you’d spend on the new vehicle would be the equivalent of cutting your income by $1,400 a year, or $117 a month for the next 30 years.”
It is actually worse than the illustration suggests. The extra 4% income also can no longer be used for reinvesting purposes. If those dollars are in a dividend growth stock or ETF, the 30 years of income is actually quite a bit more lost opportunity.
Have you taken the time to really understand the risk you are taking with your retirement portfolio? If you are in doubt as to how to go about this, reach out to me. I can provide you with some suggestions at no cost to you. You might have sector risk, focus risk, international risk, or cost risks in your portfolio, even if you have a professional advisor.