Upticks: Understanding Market Risk

By Jake Falcon on January 27, 2022

In recent years, the stock market has been on a strong and resilient run, which we think this has led to investors to become a bit overconfident. As we’ve seen recently, the market may be entering correction territory. This also means that risk has re-entered the conversation. On this episode of Upticks, Cory joins Jake to discuss market risk.

Video

Podcast

Blog

I’m pleased Falcon Wealth Advisors co-founder and COO Cory Bittner, CRPC®, recently joined me on Upticks to discuss understanding market risk. A summary of our conversation is below.

Jake: In recent years, the stock market has been on a strong and resilient run, with the S&P 500 increasing at least 15% in each of the last three years. I think this has led to investors becoming a bit overconfident. As we’ve seen recently, the market may be entering correction territory.

This also means that risk has re-entered the conversation. There is systemic risk any time you invest your money in pretty much any vehicle, including the stock market.

Cory: Yes, let’s talk about two types of risk, systemic risk and non-systemic risk. Non-systemic risk in the context of investing is risk that can be mitigated through diversifying your portfolio, while systemic risk cannot be diversified. Whether a person owns 30 stocks or 300 stocks, systemic risk will be a factor when investing in the stock market. Volatility and corrections are the price of admission for investors who want to take advantage of the returns the stock market has historically delivered.

Jake: And I would argue not investing your money in the stock market comes with its own set of risks. For most people leaving their money in cash exposes them to not having enough asset growth to sustain their retirement years. We have to be able to stomach that volatility if we want returns. Risk will be there, and that’s ok.

There are other types of risks associated with investing in the stock market. Political risks can impact a portfolio, as we’re seeing in China. Interest rate risk is relevant—if rates go up, how can that impact your investments? Inflation, which we’ve heard a lot about recently, is another risk.

There are also risks associated with certain market sectors, and diversification risk is real. It’s important to make sure you’re not too concentrated in any one stock or sector. For example, we saw technology stocks perform well for years before falling recently. There are no guarantees in the stock market, so it’s important to manage all these types of risk.

Cory: Jake, I’m sure many readers remember the “meme stock” craziness of early 2021. Many of those stocks have essentially made a “round trip” in the past year—going from, say, $20 a share, to $170 a share, all the way back down to $20 a share.

Jake: And unfortunately, a lot of people bought those stocks when they were trading over $100, because they thought the stock’s value would continue to rise.

Cory: Yes, as humans we tend to think when things are going well that they will forever, and when they’re going poorly, they will stay that way forever. That’s not usually the case, though.

Jake: In regards to investing aggressively, we advise clients to consider risk mitigation with any money they will need within the next five years. If you have money you won’t need in the next five years, that’s when you can consider pursuing more aggressive investments.

At Falcon Wealth Advisors, we generally advise clients to keep 5-10 years worth of living expenses in cash or bonds, and the remainder of their portfolio in stocks. This has the added benefit of allowing clients to tune out (if they want) news about the market’s day-to-day volatility.

Cory: Yes, and as you and I recently discussed, managing risk and chasing returns are two very different things.

Jake: That’s a great point. People love hearing about strong returns, but it’s not as fun to talk about managing risk. That’s why it’s important to not let your emotions drive your investment decisions, and to work with a fiduciary wealth advisor like Falcon Wealth Advisors who can create a financial plan you can stick to through all the market’s ups and downs.

As for emotions, it���s normal to feel both fear and greed during your life as an investor. What’s vital is recognizing and understanding those emotions, but not acting on them. It’s important to match your investments with your financial plan, your goals, your purpose and your values.

Cory: Speaking of greed, we occasionally hear about investors who assume 20%+ returns each year should be the norm. To hit a number like that year in year out, you have to take on a significant amount of risk, which is not something we’re comfortable with. As we said, it seems a lot of investors are overconfident after the past three years.

Jake: Yes, and I think back to the years after the 2008 financial crisis. Investors seemed to have more muted expectations for returns. I remember people being thrilled with the idea of 6% or 7% returns. And it makes sense they felt this way, as they saw their accounts go down significantly for multiple months.

Investor psychology is an important topic we discuss with clients. If you want to learn how you can manage your emotions and how having a financial plan can help, make sure to contact me at Jake@falconwealthadvisors.com.

Let’s next talk about how we manage risk for our clients, in addition keeping 5-10 years worth of living expenses in cash and bonds.

Cory: The first thing we should talk about is portfolio positioning. By positioning a portfolio appropriately and seeing that it is diversified – we do this by ensuring clients aren’t overly exposed to any one sector – we can help reduce risk.

Jake: Yes, and our approach to buying individual stocks and bonds for clients gives us the flexibility to take advantage of opportunities as they present themselves. For example, we’re currently researching and purchasing stocks that appear poised to outperform others in an era of inflation. If you’re invested in an exchange traded fund, a mutual fund, and/or an annuity, you likely don’t have this level of flexibility.

As inflation and volatility continue to impact the stock market, I believe it’s increasingly important to work with a fiduciary wealth advisor who is managing your portfolio and not outsourcing it to third parties. A third party managing your portfolio likely doesn’t know you, your family, or your goals and objectives. Not to mention you’re paying layers of fees if you go this route; you’re paying fees to the wealth advisor managing your portfolio and you’re also paying fees to be invested in these financial products. At Falcon Wealth Advisors, our approach driven by individual stocks, bonds, and options allows for a simplified fee structure.

Cory: And it’s worth noting if the market falls 20% or 30%, virtually any type of portfolio is going to decrease in value. But again, we focus on mitigating risk. The vast majority of our clients have already done the hard part by working hard and saving for decades. They don’t need to take risks to chase double digit returns.

Jake: Yes, and we don’t panic during periods of volatility. We encourage our clients to be patient and disciplined, and those are attributes we strive for at Falcon Wealth Advisors.

And speaking of market volatility, think about the investors who vacated the market when it fell by 30% in early 2020. Many of them have lost a lot of money by choosing to sit on the sidelines. If we achieve our objectives for portfolio diversification, the dips for our clients aren’t as severe as the overall market, and their portfolios are quicker to recover.

Cory: Let’s finally talk about how we manage risk around bonds. We prefer investing clients in individual bonds. However, some other wealth advisors use bond mutual funds. If you’re invested in a bond fund, your money is pooled with other investors in that fund.

Here’s the issue: if interest rates rise and the value of the bonds in the bond fund decline, and someone else invested in the fund needs to redeem their shares, that requires the fund manager to sell some of the bonds in the fund. And if they have to sell those bonds when they’re down in value, you can expect the value of the bond fund to decline, even though you didn’t sell your shares in the bond funds.

Jake: Yes, it’s important to know what bond fund you’re in (if you have no other choice) and how it’s performing. This is something Falcon Wealth Advisors can help you review. And if you have only have bond funds available in your 401(k) plan, we can look at alternatives.  We choose to steer clear of bond funds and instead buy bonds directly for our clients whenever possible.

If you would like to work with a fiduciary wealth advisor who can manage risk in your portfolio so you’re prepared for any market environment, make sure to contact Falcon Wealth Advisors today. You can reach me directly at Jake@falconwealthadvisors.com.

Clients choose to work with us to enhance their financial literacy and explain exactly what their financial plan means to them.