on off switch labeled risk

Working Wealthy – Risk On, Risk Off

December 28, 2021

The market has been very good to investors the past few years.

Aside from a harrowing but brief downturn in March and April of 2020, investors have been rewarded handsomely for investing in stocks.

Is now the time to get greedy?

We talk to clients all the time about risk—how much do you need; how much is too much? In fact, one of the central themes of our financial planning process is to help our clients understand the absolute minimum risk level they need to have to achieve their goals.

Why doesn’t that feel good enough?

It’s simple, we’re human, and we’re just not wired to make great decisions all the time. We’re flesh and blood—we feel emotions like fear and joy. None of us have the cold efficiency of an algorithm or computer.

Countless academics can give you scientific and data-driven answers to why we take on too much risk at the wrong times, but I’ll share a few from practical experience:

1. Keep The Party Going

The name Dr. Hermann Ebbinghaus probably means nothing to you and certainly doesn’t sound like a party guy. However, his early work on the recency effect is important for all investors to remember because it relates to recency bias.

The recency effect is essentially our ability to best remember things that happened recently and discard details that are just slightly older than the last thing we experienced or heard.

For investors, this can get toxic as it plays into a recency bias—the assumption that what has happened recently will continue. If stocks give me 20% this year, why wouldn’t they do the same thing next year?

2. I Want More

We are all prone to want more. In fact, I’ve heard the phrase “more is more” so frequently in the past year, I’m starting to think people have forgotten the original phrase.

That being said, it’s reasonable for most investors to think that making more is their right. Despite the fact that the historical long-term average return for stocks is between 8-10%, somehow, we think we deserve to get more all the time.

The reality is that to get a long-term average near 10% from an asset; we must have the big years to balance out the bad years. We must take the good with the bad—not just the more.

3. This Time Is Different

It always feels different, doesn’t it? Inflation, presidents, global conflicts, and pandemics.

During the Great Recession, many investors assumed “stocks were dead” and would never return 10% per year again—in fact, the S&P 500, a collection of some of the largest companies in the United States, actually gave investors an annualized negative return for the first decade of the 21st century.

Now all of a sudden, our expectation is that this same part of the market will regularly give us 20% per year. I’m afraid that just won’t be the case—although I’d love it if I were wrong.

In the end, it comes down to managing your risk based on the long-term plan and where you need to be in the future. Focusing on the past, especially the very recent past, can be a fool’s errand.