Market insights and analysis

By Jerry Wagner

“Nothing is certain except death and taxes.” How often that phrase has been quoted since Ben Franklin penned it in a letter to his friend, the French scientist Jean-Baptiste Leroy, in the midst of the French Revolution.

With apologies to a great American and a personal hero, I would amend Franklin’s axiom to “Nothing is certain except death, taxes, and the fact that risk is always with us.”

It’s true that the risks of our American founders and the French intelligentsia were different from those that we face today. Even in the present world, which seems to be growing ever smaller, the risks faced in each corner of it vary widely.

What is constant is that, regardless of circumstance, location, or century, risk remains an integral part of our lives. It is an everyday element … it is always with us.

We are very aware of some risk, and probably overemphasize its influence. The media, be it entertainment or network news, does seem programmed to put us in a constant state of distress. News programming has become what Dr. Norm Siegel called “a horror movie from which we don’t get to go home.” But I do not think that we should let this induced “culture of fear” overcome us.

On the contrary, as an entrepreneur, I believe that opportunities arise from taking risk. In contrast, fear of risk can overwhelm and paralyze.

If risk is always with us, but overfixation on it can be detrimental to living out our days, how should we think of risk? As with most fears, usually the best thing we can do is to learn more about it and how it affects us so that we can achieve some balance in our lives.

There are many types of risk. In investing, investors must cope with at least three main types and each must be approached differently.

Unavoidable risk

The first is probably the least likely but it sometimes seems to be the most feared. It is unavoidable risk. That is a risk that something bad will happen to you, no matter what you do. It seems there are groups of people and investors that believe unavoidable risk is a quite common risk.

With investments, whether in bonds or stocks, we know that volatility and bear markets are inevitable. Yet even with this seeming inevitability, we can take actions to seek to mitigate the effects of these declines. Asset and strategy diversification combined with dynamic risk management can help diminish the losses, even if such protective measures cannot always avoid them entirely.

Improbable risk

The second class of risk involves those that are improbable. These are risks that happen only a small percentage of the time. These lead us to one of two courses of action: ignoring them because they have a small chance of occurring or slipping into the paralysis of the culture of fear.

It’s like the constant drumbeat of conflicting cancer research. You hear that “X” can cause cancer, but the actual chance of such an occurrence is infinitesimally small.

It has been widely reported that “half of Americans are at risk of carcinogen exposure from soda.” Two facts in the research were certainly correct: About half of Americans drink a can of soda a day, AND it is true that extremely high exposure to a coloring agent in soda is a known carcinogen.

Yet, delving into the research, one learns that to be exposed to the level of carcinogen that caused tumors in rats in the study would require, according to the U.S. Food and Drug Administration, the consumption of more than a thousand cans of soda a day! I like soda (or “pop” as we call it here in Michigan), but really.

Similarly, everyone has heard a story of someone who lost everything in the Depression or even in the last financial crisis. These types of market crashes are extremely rare and yet they do occur, but focusing on them can cause paralysis.

Some investors suffered mightily during the quick bear market in 2020. Then they were punished again as they sat out the recovery that followed. They overemphasized the risk of the crash repeating itself.

There is a solution to this type of risk: working with a financial adviser to create a portfolio of investment strategies with both a defensive plan to exit the market and an offensive plan to reengage.

Probable risk

The final type of risk is probable or realistic risk. This is the type of risk that we can anticipate. We’re told that if you smoke, lung and breathing difficulties are likely. If you drive a car, an accident of some sort during your driving career is probable.

Probable risks are indeed everywhere around us. They permeate our lives. Yet, despite their numbers, our minds are trained to weigh them all as they appear, and then immediately take action.

The human mind was designed to deal with these probable risks in this very basic way. And it worked very well for our early ancestors. They had to decide instantly whether to fight or run, and our ancestors survived a hostile, primitive environment as a result.

But the more complex decisions called for by modern life are not so easily handled by the chemistry of our brains. Studies show that we humans are not very good at weighing probabilities. Even studies of statisticians show that they are easily misled by the circuitry of our brains to reject the more probable of two outcomes.

This is often caused by an overreliance on recent experience. For example, many of us take a down day or week or quarter in our investments and extrapolate that experience into the future, and then we become frightened.

It is also caused by the fact that humans fear loss more than they appreciate gains. In fact, the studies show that the fear of losing a dollar has a greater influence on a prospective investor’s decision-making than the opportunity of a gain of more than two dollars.

As a result, it is easy to see why some investors have let the recent market activity keep them from sticking to an investment plan or strategy. This fear of loss can even overshadow the joy of future new highs in the stock market. It can then cause an investor in a stock, bond, or strategy to abandon that investment in the face of a recent quarterly loss.

Yet I am relatively certain that when the investor chose that stock, bond, or strategy, he or she was not relying on a single quarter’s return in making that decision. Instead, they were probably persuaded by a history of higher returns earned over years, not just a single quarter.

While our mistaken weighing of probable risk can lead us down the wrong pathway, there is a very positive side to this class of risk. Probable risks are anticipatable and controllable. You can stop or limit your smoking. You can get insurance for that car accident to come. You can reformulate your portfolio.

A solution to all three types of risk

Dynamic risk management can help you deal with all three types of risk in your investment portfolio. Bear markets come in two varieties: probable baby bears that are short, frequent, and shallow (20% or less in downside risk) and improbable but unavoidable super bears (when the market falls more than 20%) that are rare, long, and deep.

To cope with the baby bears, simplistic passive allocation can be an effective tool. Even better, in my opinion, is a multi-strategy core portfolio.

Multi-strategy core portfolios are suitability based and use multiple strategies that include asset-class diversification, strategy diversification, and dynamic risk-management measures instead of just the simple asset-class diversification employed by passive asset allocation. These can keep investors engaged in the market most of the time and help them avoid whipsaws and quick corrections that are sharp but shallow.

In contrast, tactical strategies (Classic, QFC Self-adjusting Trend Following, and Volatility Adjusted NASDAQ) and dynamic rotation strategies (Evolution, Market Leaders, and Fusion) are best used in the “explore” portion of one’s portfolio, designed with super bear markets in mind.

The former can move completely out of stocks when necessary to avoid the 50%-plus losses of the super bear. The latter can move increasingly defensive as the market descends until at some point they move completely to cash or bonds to sit out the really steep part of the decline. Both have tested methodologies for returning to stocks when the coast is clear.

By combining multi-strategy core portfolios for baby bears and tactical and rotational explore strategies for super bears, an investor can build a portfolio that addresses all three types of risk. Dynamic risk management makes this possible.

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Each of us must remember that risk is real and that, like death and taxes, risk is always with us. We must remember this not to be paralyzed by risk but rather to anticipate and control it.