This is the proprietary thesis of Dollarlogic and what separates Martin's message from the rest of the "buy, buy, buy!" investment industry. Risk does not equal reward in relationships, behind the wheel of a car, or in any other aspect of life, so why should it in the highly varied and sophisticated world of investing?
In Dollarlogic, Wall Street veteran Andy Martin explains what risk really is, why stocks are actually less risky than bonds, and why predicting yourself is more important than predicting the stock market.
The new investment philosophy of Dollarlogic will show you how and why to make the important changes in your investing habits that could make a meaningful difference in your life and legacy. Although it may be true that money can't buy happiness, it can buy just about everything else!
In this practical and readable book, you'll learn:
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~ DAY 1 ~
Risk ≠ Reward — Understand Risk: It Is Not What You Think
"To him who looks at the world rationally the world looks rationally back."
— Georg Wilhelm Friedrich Hegel
Risk does not equal reward.
The phrase is illogical. Instead, if you wish to unite the words to their meanings, the phrase should read risk = risk, or reward = reward. Any other association of the words is sophistry or salesmanship. The investment industry, being the chief promoter of this errant formula, should stop using it, because it is misleading and simply wrong.
Philosopher Ludwig Wittgenstein's elegant principle of logic yields this simple truth: A is the same as A. This is sometimes expressed in the symbols of logic: A [equivalent to] A where "[equivalent to]" means congruence or two subjects of equal identity. To the contrary, it is absurd to say that risk is congruent with reward, or that risk is identical to reward. Worse, the assertion that risk = reward makes investors believe that dangling at the end of risk is inevitable reward, or that one must necessarily pass through the gauntlet of peril to reach promise on the other side.
Risk = reward associates risk with something positive and links the two as if they were necessary co-ingredients, like water + flour = bread.
I am risk averse. You should be, too. Remember what we are talking about: Your investment is your hard-earned money. If you do not do this right you may never have any more money on which to practice. And, according to a recent AARP survey, "[r]unning out of money (is) worse than death." There is no quicker way to run out of money than to take big risks.
What Is Risk?
It is important to know what risk is and what risk is not. Faulty characterizations of risk lead to undesired results. This is how many stock averse investors think:
Risk is volatility.
Stocks are volatile.
Therefore, stocks are risky.
Instead, risk must be measured against returns. For example, the notion that Treasury bills are low risk is simply untrue when you factor in the return. In Japan and currently for some bonds in the United States, bond yields are so low that only the principal is returned. So what is risked is any potential of return. One could hardly call this a low-risk investment — that is, if your purpose is to increase your wealth.
Since biblical times, investment return assumes some quantity received in addition to the principal — the lesser of that quantity, the worse the investment. Recall the parable of the nobleman and his three servants from the Book of Luke. The first servant returned 10 mina (mina was the equivalent of roughly three months' wages) more than was given him; the second servant returned five mina more; the third servant returned only the original mina. The nobleman's severe response to the risk-averse third servant was, "Why then didn't you put my money on deposit, so that when I came back, I could have collected it with interest? Take his mina away from him and give it to the one who has 10 mina." Think of that story while we discuss the relevant definition of risk for savers and investors.
A New Way of Thinking About Risk
Risk is the possibility of suffering loss or harm. Risk is a relative, not an absolute, measure. Dying, for example, is not a risk. Dying is an absolute: We will all die. If someone asks you what your probability of dying is, your answer would be 100%. However, if someone asked you what your probability of dying within 10 years, or in a car accident, or after viewing your 401(k) account balance, this is an entirely different question, and needs a complex calculation. Risk is measured only in relation to events, consequences, or time. The risk of dying escalates with certain factors such as smoking, not wearing seatbelts, eating fatty foods, and so forth. Therefore, it is not the risk of dying that should cause concern; it is the risk of some unwanted event leading to an early death.
Think of it this way: Would you rather be in a car crash or a plane crash? If you answered car crash, the next question is: Would you rather travel one million miles by car or by plane? If you answered by plane, I might ask why, as you just said that cars are less perilous. You might respond, It depends. If I am traveling 5 miles to a friend's house I would rather take the car, but if I am going to travel an eight-state region over a 10-year sales career it would be safer to fly. And you would be right.
The Boeing Company claims that it is 22 times safer to fly than it is to drive on a per-mile basis. Fewer people have died in commercial airplane accidents over the past 60 years than are killed in U.S. auto accidents over a typical three-month period. Another study indicates that you have the same chances of dying in a car (one in a million, a MicroMort) having traveled only 240 miles, versus traveling 7,500 miles by commercial aircraft. How can this be? Which one is actually safer? How can it be that sometimes driving is safer and at other times an air travel is safer?
Cars are not safer than airplanes. Airplanes are not safer than cars. Instead, safety (or risk) is dependent on the distance traveled. Again to accurately assess risk you always have to measure against the objective. If the objective is a short trip, driving is safer. If the objective is a long trip, flying is safer.
This is much like the benefits of exercise. Exercise is short-term risky when measured against chance of injury, and long-term healthy when adding back the net health benefits. You have a greater chance of injury if you take a 3-mile run or spend an hour in the gym lifting weights versus staying at home and sitting on the couch. To put a number to it, "More than 3.5 million (sports) injuries each year, which cause some loss of time of participation, are experienced by (children and teens)." However, long-term exercise is a proven contributor to cardiovascular health, weight control, muscle and bone strength, lower blood pressure and cholesterol, and even relieving depression. Time converts the greater short-term injury risk into a longer-term health benefit. Can you see how risk is actually lower long term by taking part in short-term "risky" exercising?
Risk, then, because it is a relative term, should be measured as a function of the objective. In this case the relative measure is time. As an investor, how much time will it take for you to grow your principal? What will happen over the long term? In 10, 20, 30 years from now, what will your needs be for your money? The objective is not, not (sorry for the double negative) to lose money on any given day. The objective is to reach your long-term goals. Therefore the safest and most reliable way to do that should be preferred.
Never Bring a Knife to a Gun Fight
There are multiple ways to visualize this new definition of risk. Is a gun or a letter opener riskier? It depends. If you replied gun, which would you rather have if someone attacked you? Most would agree that a gun is a more reliable way to neutralize a dangerous threat than a letter opener. Which is riskier: a vitamin or tetracycline? Would you rather your baby swallow a vitamin or tetracycline accidentally? It depends. If she was suffering from an infection you would rather her swallow tetracycline.
Another example: How would you like to have surgery today? Most see surgery as a risky procedure. For starters, you have at least a one in 200,000 chance that you will die if you have surgery. According to the Centers for Disease Control and Prevention, approximately 2 million people a year contract infections during a hospital stay, and more than 90,000 die as the result.
The point is this: You do not decide to have surgery instead of doing nothing; you decide to have surgery instead of suffering the consequences of not having the surgery. Therefore risk is not an event measure (Do I have surgery or not?); risk is an outcomes measure (How will my long-term health be affected?).
This is the same with investing. You don't invest in the stock market because it is safer. You invest in the stock market because if you do not, you have less likelihood of reaching your financial goals.
Risk: The Noun
Risk is a misunderstood word. How we understand words — more importantly, how we use words — is crucial. If you doubt this, see how the word love is used. It is a word so charged with expectation that the mere mention of it can change a relationship. It is the same with the word risk. Use both carefully.
How you think about and use the word risk will determine what kind of an investor you are. Risk can be a noun, verb, or adjective. My advice is this: Use the word risk as a noun and you will have a better future. And, make you, not the investment, the subject. When you use the word risk regarding investing, ask Am I putting myself at risk? Do not ask about a proposed investment Is this risky? Don't ask Are emerging market funds risky? Ask Will this emerging market fund put my objectives at risk? There is a crucial difference.
This will help you focus on you and your investment goals and not on the much-less-critical discussion about the investment vehicle. Plus, you are much more capable of evaluating your own risk tolerance than you are the risk of an investment. Far too much time is spent in comparison of this and that data point of a particular investment. We ask questions such as: What's the beta? What's the 10-year track record? What asset class is it? Better questions are: What income do I need to have in 20 years? What is my current debt level and how can I reduce it? What investment amounts and returns do I need to reach my goals? My recommendation is that you quit asking questions about investments and start asking questions about you. The wealthiest people I know have no more investment knowledge than you do, but they have detailed personal goals, objectives, and plans. They simply match investments to their plan.
A more ideal use of the word risk will make the discussion less subjective. You are the object, and your goals, not your investments, are the objective. You are the focus, not your tools. We will see in a later chapter that it is investors who make money, not investments, so begin now to wean yourself off the obsession over the investment rather than you.
I have dealt with clients over the years who tell me, "Andy, I just don't want to take a chance. That's why I am just going to leave everything in CDs. At least then I am not buying something risky." Instead, they should ask, "I wonder if there is anything that I am doing to put my retirement goals at risk. Is investing everything in CDs putting me at risk?"
The answer is Yes. The relative low returns of CDs (certificates of deposit) could put your retirement income at risk. CDs are not risky, but depending on CDs for your future income needs is risky.
Similarly, there is no doubt that driving 10 miles per hour is less risky than driving 60 miles per hour. However, you would be putting yourself at risk if you drove 10 miles per hour on the interstate. You would also be putting your sick child at risk if in an emergency you drove him to the hospital at only 10 miles per hour.
Risk as a condition or state has to be dealt with in much more analytical terms than risk as a discrete act. In other words, doing less-risky things can put you more at risk. The risk of the speed you travel, and the investment you choose, is dependent on the objectives of your journey, and the objectives of your savings goals, respectively.
Stocks are riskier if you need the money for a down payment for a new house at the end of the month and less risky if you need to accumulate more assets over a long period of time. The right investment (or speed) will become very clear after you have determined your objectives.
Volatility Higher Returns
Associated with the errant concept that risk equals reward is the related assumption that volatility equals higher reward. Think about this in the physical world. To say that the average must be higher because of greater volatility is irrational. An analogy is average temperatures. Did you know that San Diego has an average temperature of 70.5 degrees and Atlanta has a lower average temperature of 61.3 degrees? (See Figure 1-1.) Therefore, temperatures in San Diego are more volatile, right? This must be the case if higher volatility equals a higher average, right? Wrong.
The Atlanta Chamber of Commerce is famous (or notorious) for selling the International Olympic Committee (IOC) on this hilarious notion. Atlanta convinced the IOC before the 1996 Summer Olympics that the temperatures were much cooler than they are by averaging in nighttime temperatures. Athletes would soon discover that 65-degree nights don't make up for 100- degree days.
The greater volatility in Atlanta's weather should mean higher average temperatures if it is settled science that greater volatility = greater returns. Atlanta average daytime temperatures are much more extreme than San Diego temperatures, but Atlanta is cooler on average.
What I am suggesting by analogy is that there is a San Diego way to invest. You can get to a comfortable room temperature from consistent 68- degree days more reliably than you can get to 68 degrees from an uncomfortable combination of 33-degree and 90-degree days. There is another way to reap higher returns than through unpredictability and numerical frontal assaults on your life savings.
Risk Is a Function of Time
Risk needs to be measured against not just loss, but the timing of loss. For example, life insurance policies don't protect the insured from dying. Nor do the policies assume that the person will live forever. Life insurance policies protect against an early death.
However, the risk measure for the timing of life insurance policies is opposite of the timing for stock investments. Visualizing this helps to understand the time connection of risk for stock investing. Nothing beats the returns from premiums paid into life insurance policies that pay off early. And nothing beats the returns from stocks that pay off late. The odds are in your favor the longer you invest. Thus, the risk of life insurance increases over time, but decreases over time with stocks.
How is this incremental value for stocks valued over time? Using history as our guide (and it is the best guide we have) there was a 3:1 chance that the stock market rose in any given year, and a 100% chance that you would have made money for any 20-year period or more.
Why is this important? Because of this: The average 65-year-old couple can expect to live another 19 years. In addition, there is a 50:50 chance that one member of the couple will live beyond 92, and a 25% chance that he or she will live beyond 97. You need stocks now more than ever because you are going to live longer. No generation until now has ever had to anticipate living in retirement for 30 years, but Social Security now only replaces about 40% of pre-retirement income for today's average worker.
For a wider perspective, over the last 85 years stocks were up 72% of the time, down 28% of the time, beat 5% returns 68% of the time, and had an arithmetic average yearly return of 11.50%. Getting theses odds in your favor will lower your risk.
My belief is risk does not equal reward, and I am attempting to change the way you think about risk. But, let's get back to the real world for a minute before I get into too much investment detail. Let me ask you if risk = reward with a few questions:
* Do you ride motorcycles without a helmet?
* Are you happy when your daughter introduces you to her new tattooed, out-of-work, ex-felon boyfriend?
* Do you juggle chainsaws as a hobby?
* Do you drink alcohol by the bottle rather than by the glass?
* Do you refuse to wear eye protection when you use your weed-eater around the yard?
* Do you walk close to the edge of cliffs when you hike?
* Do you avoid sunscreen on a long day at the beach?
* Do you fix shingles on your roof on the day of a snowstorm?
* Do you leave your doors unlocked and outside lights off every night?
* Do you exaggerate and lie on job applications?
* Do you eat junk food at every meal?
* Do you refuse to wear seatbelts?
Your answer, I am guessing, was no for all or most of these questions. Each question was the same: Are you a risk taker? Notice that there is virtually no part of your life in which you seek risks. Instead, you avoid risks as a good habit. So, how could it be that in one very narrow but vital part of your life it would pay to ignore everything you believe? How could it be that investing is that one area of your life where taking big risks is advised?(Continues…)
Excerpted from "Dollarlogic"
Copyright © 2016 Andy Martin.
Excerpted by permission of Red Wheel/Weiser, LLC.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of Contents
Executive Summary: Dollarlogic in One Page,
Foreword by Arthur B. Laffer, PhD,
Day 1: Risk ≠ Reward: Understand Risk: It Is Not What You Think,
Day 2: Stocks Are Less Risky Than Bonds: Your Objectives, Not the Investment, Determine the Investment's Risk,
Day 3: Seek Lower Returns: Reducing Losses Is More Important Than Increasing Returns,
Day 4: Predict Yourself, Not the Stock Market: Establishing Your Goals Is More Important Than Guessing the Market,
Day 5: Investments Don't Make Money — People Do: Hiring an Advisor Is the Best Investment Plan You Can Make,
Day 6: Do Not Chase Returns, Chase Odds: Diversify — But Diversify Wisely and Widely,
Epilogue: On Money and Happiness,
About the Author,