Strait Talk Blog
5 Reasons You Must Take Risk To Achieve Complete Financial Independence
How The Risk-Reward Paradigm Benefits Long-Term Thinkers
Chief Business Development Officer, Founder
Cory Baer is the Chief Business Development Officer for Strait & Sound. In this role, he fulfills a dual mission. First, he serves clients by ensuring that they have the best possible financial plan to achieve their long-term goals, particularly complete financial independence. Second, he also serves as an ambassador of the Strait & Sound brand by introducing the firm to the larger community and select strategic partners.
My colleague Todd Sixt wrote a couple of great articles about achieving complete financial independence. In this article, I want to expand on an idea Todd presented that I believe will have a major impact on this goal—risk. My thesis is simple. Most people in this country will have to take risk to achieve complete financial independence. However, this is a topic that makes a lot of people uncomfortable. I totally understand that. Risk makes me uncomfortable too. None of us want to lose our wealth.
After more than a decade of serving clients in the financial services industry, here is what I’ve learned. Not all risks are alike. There are some risks I believe you should take and others you should avoid. Yet, after working with hundreds of clients, my observation is that most people are not taking enough of the right kinds of risk and sometimes take the wrong risks. Here are five guiding principles about risk that can serve you well as you work toward achieving complete financial independence.
What Is Complete Financial Independence?
Just so we’re on the same page, I want to clarify how we think of complete financial independence at Strait & Sound. This is about achieving a certain position in life where:
- Your lifestyle is comfortable, but reasonable and disciplined.
- Your cash in-flows are substantially more than your cash out-flows monthly and annually.
- Your income sources and assets are diversified so that losses in any one area do not force you to alter your lifestyle: social security, cash, investments, pensions, real estate, etc.
- Your income sources will continue to produce more than you need for the rest of your life.
- You may or may not be working for money, depending on what you want to do with your time.
- You have the right set of advisors around you to give you great counsel when you approach forks in the road.
- If necessary, and especially as you and your loved ones age, you have people you trust around you to help manage your financial affairs.
Given this definition, the question then becomes—what role does risk play in achieving this?
Five Guiding Principles For Thinking About Risk
I want to say this for the record. Not everyone needs to take financial risk and some people shouldn’t take it at all. If you are struggling to put food on the table, food is more important than taking risk in the stock market. If you’re struggling to pay for housing, I wouldn’t advise you to take risk in the markets. In other words, I don’t think people should risk money they need to live on.
However, there are literally millions of families in this country who do have monthly discretionary income. Yet, only a small portion of these families will ever achieve complete financial independence, the way I’ve described it above. There are multiple reasons why this won’t happen, usually because people don’t follow a long-term financial plan over many years.
But there is also another culprit—making the wrong moves with risk. Most people, in my experience, don’t take enough of the right risks. Others take inadvisable risks. I find that risk often puts people in a flummox, where they seem to struggle to think clearly and act with confidence. To help address this, I’d like to put forward five guiding principles about how to address risk in the healthiest way possible.
- No risk equals no reward.
- Time-in-market beats timing-the-market.
- Smart risks are your friend and dumb risks your enemy.
- Long-term risks are better than short-term risks.
- Risks are a team sport not a solo act.
No Risk Equals No Reward
In general, I believe risk is our friend, not our enemy. I tend to think about risk like electricity. If you use it well, it can light and warm your house and bring you endless hours of entertainment and connections to loved ones. Or it can burn your house down. The difference between these two outcomes—a comfortable and well-lit home versus charred ruins—depends on how you use electricity. But can you honestly imagine living in a home without electricity and modern conveniences?
Just as we have learned to harness the power of electricity to improve our lives over the last 150 years or so, we’ve also learned a lot about risk, particularly investment risk. For instance, did you know that the markets, on average, have only been in a bear cycle for 22 months before coming out of it? Think about that for a moment: 22 months. In the scope of a long-term financial plan, that’s barely a blip on the radar screen.
And yet, bear markets have such a strong psychological impact on people, causing some people to become risk-averse. When the markets dip, so many people are inclined to engage in the behavior that is exactly the opposite of what works: buy-low—sell-high. When people sell-low in a bear market, they lock in their losses. They remove any possibility of a recovery.
For example, Apple stock in the 1980s cost about $2,200 for 100 shares. If someone held those shares until today, they would be worth around $1.1 million. But along the way, Apple’s stock was up and down and so were the markets. If someone exits the markets simply because things go down, they miss the opportunity to go up. I have come to believe that being risk-averse often costs you more than being risk-tolerant.
Key Take Away
“Being risk-averse often costs you more than being risk-tolerant.“
Time-In-Market Beats Timing-The-Market
Timing-the-market is about making moves at just the right time so you cash-in on short-term gains. Time-in-market is about buying, holding, re-balancing when necessary and letting it ride. Timing-the-market is risky, the stuff of day-traders. Time-in-market is far less risky and it’s available to nearly anyone with discretionary income, not just day-traders.
Timing-the-market, I believe, is a risk most people should NOT take. Time-in-market, on the other hand, is a risk I believe most people SHOULD take. Why do I say this? We have yet to see a case study of anyone putting money into the stock market and letting it ride for 40 years, while making the occasional re-balance, where they were not far better off at the end of that 40 years. Give it enough time and the payoff could be huge.
For example, AmGen stock was trading at around $50 a share in the late 1990s and paying a $.50 per share dividend. In March of 2021, AmGen was trading at around $240 per share and was paying a dividend of 2.78% ($6.72 per share). That’s a 500% gain. And yet…
- In January of 2000, it was trading at $65.88.
- In September of 2002, it was trading at $45.
- In March of 2008, it was trading at $39.
As the data shows, it took more than twenty years for AmGen stock to produce very attractive returns. An impatient person trying to time the market probably would not have waited that long. But a patient person who practices time-in-market would have reaped the benefits. Time-in-market wins—every time.
Smart Risks Are Your Friend But Dumb Risks Are Your Enemy
I believe there are smart risks you should take and dumb risks you should avoid. For me, the difference between smart risks and dumb risks comes down to four things:
- Time—the shorter the timeframe to ROI, the higher the risk. The longer the timeframe to ROI, the lower the risk (most of the time).
- ROI—is there enough ROI to make the risk worth it?
- Research—is there a lower-risk alternative that could produce a similar result?
- Diversification—is the portfolio diversified enough to withstand volatility?
In general, I think fast money is dumb and slow money is smart. This is hard for a lot of people to accept. As a society, we have become addicted to instant gratification. We want it now. But building wealth in a reasonable way that doesn’t expose you to too much risk all at once—well that can take a lifetime. Get-rich-quick schemes usually benefit the schemers, not the investors. One of the biggest mistakes I’ve seen people make over the years is betting the farm on an investment that must pan out soon or they’ll be wiped out. Smart risks, by comparison, give you time to make pivots if necessary.
ROI is another criteria I use to help my clients decide if what they are considering is an advisable risk or not. For example, if you risk 1 million dollars to potentially earn 10 million dollars, that risk might be worth taking. But if you risk 1 million dollars where it’s clear that the best-case upside is only 2 million dollars, that risk probably isn’t worth it.
Now let’s look at research. Whenever a client is considering a risky move, I advise them to do as much research as possible and to give us time to do it with them. Two heads are better than one. Let me give you a couple of examples where research can bring real clarity to the picture.
- Life insurance. Most people today have the option to buy term or whole life insurance. Which makes sense? That depends on a lot of factors including your long-term income needs, your tax situation, your goals for your family, your age and your health. In my experience, the best approach is to model out long-term projections for both whole and term. This approach can help you make informed decisions based on real-world projections.
- Monthly savings. Many households set a monthly savings goal. But what do they do with the savings? Let’s assume it takes two years to build a reasonable nest egg equal to six-months or more of living expenses. Then what? What do you do with the savings from year three to retirement? I often find that classic savers are not good risk takers. At a time when their basic financial security needs are met, putting them in a position to take more risk—they do the opposite. They just keep saving month after month without taking the kinds of risk their situation warrants. To help with this, we build financial models that show them what their long-term situation will look like if they simply keep saving versus if they take some level of risk with investing. This research, seeing the financial results in black and white, brings real clarity to their situation. It gives them confidence, most of the time, to take smart risks.
Now let’s discuss diversification. This is an area where I see “successful” people often making two common mistakes: misunderstanding diversification and having too much net worth concentrated in company stock. First, let’s look at misunderstanding. I’ve heard more than one person, through the years, say things like: “oh yes, we’re well diversified because we own both Apple and Google.” That’s not diversification because they’re both technology stocks. A good rule of thumb is at least three. For example, a portfolio comprised of technology, retail and manufacturing stocks is much more likely to withstand volatility and losses in any one of those areas without being wiped out.
Second, let’s talk about company stock. Many senior executives and business owners have stock options from where they work. But over the years, I’ve seen way too much concentration of personal net worth in company stock. In some instances, up to 40% of a person’s net worth can be tied to their company stock. This is not an advisable risk to take, even if you’re an owner.
Long-Term Risks Are Better Than Short-Term Risks
Some people seem to think that those of us in the financial services industry have access to a secret sauce, as if we know short-cuts that we aren’t willing to share until someone becomes our client. After more than a decade in this business, I can say with real conviction that I don’t believe in secrets or short-cuts.
If I knew about them, I would dump all of my money in them, buy an island in the Caribbean and drink Mai Tais for the rest of my life. You may notice that I’m still a working professional. Why? Because I know that long-term plans produce real results and short-cuts, most of the time, are way too risky. Let me give you a real-world example that has nothing to do with investments or the markets.
A client came to me a few years ago and wanted some advice. His child had an entrepreneurial bent and had investigated a business model that could do really well. But the child needed seed capital to the tune of $100,000. My client wanted to know whether or not the risk was worth it. I did some research and could see the upside to the business model if it took off.
I took a look at the client’s long-term financial plan and gave him this analysis. “If your child’s business completely fails and you lose all $100,000, you’d likely have to work about 3 years longer than you had planned. But if the business thrives, you could achieve a level of net worth that you’d never otherwise be able to see, given your current path in life.”
For this client, the long-term risk was worth it because his worst-case scenario really didn’t impact him financially all that much. He could still achieve the goals that were in our current plan even if his child’s business failed. But if it succeeded, he could potentially retire a decade earlier than we had projected and still have more than enough income for the rest of his life.
Risks Are A Team Sport Not A Solo Act
The example I provided above illustrates this point. To take risk, you really do need advice and counsel from someone who is a professional, someone who knows you and someone who can be dispassionate in looking at the numbers. One of the biggest mistakes I see people make, a mistake that often leads to serious regret, is making decisions without the input of a trained professional.
Big decisions usually have big consequences. I find that my clients do best when they have a team around them to help them make big decisions with confidence. I think of this, in some ways, like mountain climbing. Climbers have to reach the summit on their own feet. But the best climbers have a team around them, providing food, setting up and taking down camp every day, judging the weather and ultimately standing by if they’re needed in an emergency. Do you have a team around you?
Risk is a subject that makes a lot of people, including me, uncomfortable. In my experience, most people take too little risk. Others take inadvisable risks. These five guiding principles have served me and my clients very well:
- No risk equals no reward.
- Time-in-market beats timing-the-market every time.
- Smart risks are your friend and dumb risks your enemy.
- Long-term risks are better than short-term risks.
- Risks are a team sport, not a solo act.
Who is your adviser when it comes to risk-taking?
We Provide Comprehensive Wealth Management Services For People Seeking Complete Financial Independence
Register For Blog
Please fill out the form below to sign up for the Strait Talk newsletter.