Understand risk behind the wheel of a racecar

It took me quite some time in my professional career to grow comfortable and confident speaking with clients about risk and risk tolerance. Mostly because “risk” is very poorly defined by most financial professionals, I can understand how this comes to be.  You are the new guy/gal at a venerable firm with many hard-working, intelligent, successful colleagues, and you are looking to avoid asking elementary or profoundly philosophical questions, ie, you don’t want to be the new weirdo in the office. Risk tolerance is supposedly both how you feel now and your feelings about hypothetical situations, which has always made me suspicious.

I’ve grown to understand the problem is that both professional and amateur may not fully understand what they mean by risk. I’ve made the cardinal sin of saying risk is volatility to sound smart, not fully grasping that is a profoundly dumb and half-baked way to talk about risk.  First, nobody in the normal world talks like that, saying risk equals volatility.  Second, it is more likely that that person is trying to say something smart and noble, but it can be counterproductive and/or mildly offensive if you are speaking over the head of your intended audience.  Through this thought experiment, I’ve come to borrow my new definition of risk from others.  Risk should be understood as something turning out other than you had planned.  

As a simple example, I’m sure the purchasers of Ark Innovation ETF in February 2021 did not plan to watch their capital incinerate over the following twelve months.  This tongue-in-cheek example highlights the point that risk, by definition, must be an unknown.  As an aside, I’d like to totally ban the term “upside risk” from conversations with regular investors about their investment portfolios. This term is too often used by professional investors trying to in vain to predict the future. 

Many in the financial planning business build a risk tolerance questionnaire as part of initial relationship start-up. I must underline before I proceed further, that I am not against the questionnaire, my contention is with the presentation of risk. A risk tolerance questionnaire will generally use a series of questions about hypothetical scenarios to judge how you feel and would react to the riskiness of investments. Absent from these usually well-intentioned questions is a true emotional response that comes with markets “turning out other than you planned.”  Generally if the stock market is down 20-30-50%, other things are going badly in the world outside of the stock market.  

Consider the onset of Covid-19 in March of 2020.  The market had violent downside moves coinciding with incredibly anxiety-filled macro events. There was nothing wrong with a person who filled out a questionnaire stating they were “aggressive” considering selling and not increasing their investment holdings as they claimed they would when filling out the questionnaire. In fact, they are simply human beings who act rationally.  From a narrow market perspective, we can all discuss those rough weeks we went through in March in sanguine terms now, but to not understand how close we were to the precipices would be ignorant at best. I shudder to think of what would have happened without the Fed increasing its purchases of treasury bonds from a set number to unlimited. 

A more practical way to look at risk

I might brag that I would really enjoy driving a 1989 Ferrari F40 at full speed around a race track, but sadly this would be a lie.  During the only track day I have participated in, putting the accelerator down to the floor was not the issue as much as bravery on the brake pedal.  To improve your lap time, you must achieve the highest average speed possible around the track (no $&(%!).  To do this, you both need to go fast AND brake as late and smoothly as possible to hustle the car around corners in the most efficient way possible.  I found it easy to claim, I wasn’t driving a Ferrari by the way, that I would brake late and be solely focused on the racing line. The first time the car truly warmed up and the brake pedal traveled further than I expected before engaging the hot, ironically grippier, brakes I was no longer that brave.  I was especially considerate as one of the hardest braking zones of the track had you face-to-face with oncoming guardrails.  As a father of two, I was looking to win no awards for bravery at that turn.  My lap performance improved when I was able to get feedback from a more seasoned driver in the passenger seat.  The advice was that “smooth is fast and fast is smooth” as I was very jerky on both the accelerator and brake pedal.  My lap times improved with this feedback, more laps behind the wheel, and a greater understanding of the limits of the car I was driving.

I use a racing analogy for two reasons; first, I love talking about cars and racing.  Second, and more importantly, a colorful analogy helps hammer home more esoteric ideas. We can all imagine our financial plans as a race we need to win.  We all have different races and cars to drive in this race analogy.  We could all benefit from expert advice and feedback as to where we need to be more judicious on the brakes and, at times, hit the gas harder. Saying what we would do behind the wheel versus actually doing it can help the mind begin to plan but could serve little purpose when careening towards a guardrail, trusting the middle pedal.  Mike Tyson is quoted as saying, “Everyone has plans until they get punched in the mouth”.  

A good financial professional should help you understand what lap times you need to hit your goals (your financial plan).  What vehicle and features are best for your race (your portfolio of investments).  How and when should you speed up or slow down (the risks you need to take). And whether you should even drive or be the passenger (discretionary versus non-discretionary).  Risk in this scenario is not the consistency of one lap to another (remember the term volatility); risk is more likely when you press down on the brake pedal, and something unexpected happens. This is the risk I believe most of my clients are focused on and not some stuffy saying like “downside volatility.” I’ll end with one of my favorite quotes about going fast that could also be translated to market wipeouts.  “Speed has rarely ever killed someone. Coming to a sudden, unexpected stop is what has done most folks in.”  

Why did I take you on this roundabout journey (no pun intended) to discuss risk? In the spirit of continuous improvement on my craft and process, clearly communicating new-found thinking on a topic ensures a greater ability to understand and implement improvements fully. I am working to ban myself and those I can influence from using the interchanging words volatility and risk. Further, a core belief I hold when making investment decisions is that simple is always better; thus, we can simplify a conversation around risk and use risk to our advantage. Finally, I have a passion for my craft of investment management and believe it has many crossovers in life.  For example, I have noticed my ability to become more patient with investment decisions since becoming a father. I am sure all the parents reading this can understand this lesson without saying more. 

In the coming months, I will lead the firm's efforts to build a formalized investment management program. This entails the construction of portfolios for other advisors at our growing firm, many of whom do not enjoy and would prefer the expertise of a more seasoned investment professional constructing the portfolio.  In this capacity, I will also assume the title of Chief Investment Officer of Fiduciary Financial Advisors. While I would be the first person to admit that title inflation often occurs in the financial industry, I am taking this role extraordinarily seriously.  I do not foresee any changes to working with my existing clients, but will become very selective about the new clients I take into my practice. That said, I feel emboldened that I can work to serve more individuals and families via money management done the right, fiduciary way.  

“I write so that I can think” is a quote attributed to John Adams that I fully understand. Risk and return are to each other what light is to dark.  Simplifying an understanding of risk to manage it better can only benefit our investment return potential. 

I appreciate your time reading my views on this topic and hope they are thought-provoking. As always, I am happy to hear from you with any questions, comments, or just to say hello.  

Be well and invest for the long run, 

rob

Robert A Barcelona

Senior Financial Advisor

Fiduciary Financial Advisors

President HB Wealth Management, LLC