What do Christmas lights have to do with investment risk?

by Ralph Bender, MBA, CFP®

Thanksgiving weekend is my time for stringing Christmas lights and that requires using a ladder. I’m in pretty good shape for my age, and with my years of experience, I’ve got a pretty good understanding of how to be safe on a ladder. Frankly, I’m a lot more cautious than thirty years ago.

I use my six-foot step ladder for all the low stuff, because on it I can reach what I need from the third rung. And I can use it to get up to the eaves under the low gables of my house, but that requires me to climb up to the top rung. When I’m there, I’m extra cautious about the ladder’s footing so it’s very stable. When I want to get onto the roof, I could use the top platform, but that’s not a good plan. It’s a bit too long a reach, so I’ll get the extension ladder instead.

The six-foot step ladder is a good analogy for our investment objectives, which defines how much risk or volatility we target when working with our clients. Money that cannot have any risk stays on the ground, which should remain stable. (Let’s ignore the earthquake possibility for this analogy but recognize that even solid ground can surprise us.) This money is the emergency reserve, the money to pay the current bills, in short, the money in checking, savings, or CD accounts.

But most investment portfolios are intended for future use, so we need to get on the ladder, get the money invested and take a bit of risk. Ladders that are in good condition are pretty safe when the capable workman gets on them. Likewise, a wisely constructed portfolio, in the care of a capable financial advisor, can get the job done.

On my six-foot stepladder there are five usable rungs, plus that top platform I rarely use. As I climb the rungs, there’s less ladder above me to hang onto, and the drop to the ground is longer. In our portfolios we also have five investment objectives, and the money needed in the near future stays at the bottom levels while money intended for the long run goes higher up the risk profile.

Now let’s digress a moment about this scary word “risk.” It’s something that our industry bandies about without ever explaining. Most people think it is the same as “loss.” It’s not loss. It’s something with an uncertain outcome. And the most important outcomes are the good ones: getting the lights up for Christmas or growing a portfolio to achieve a sustainable lifestyle after leaving the workforce. It’s a known axiom that greater rewards come with greater risk, but the opposite isn’t true. Taking great risks increases the chance of failure. And in the context of our five rungs of the stepladder, we’re not expecting to lose money because we know how to build it to avoid locking in the losses when inevitable volatility shakes the ladder. And volatility, the ladder shaking, is what our industry defines as risk.

Volatility happens. It’s driven by the emotions of the market or the noise of the media. But in our analogy, the ladder is set on solid ground, rooted in the capital markets, a system through which individuals share in the earnings or collect interest as owners (stocks) or loaners (bonds) to businesses seeking profits.

Visually, the wide base represents the amount of fixed income that is involved at each level and it decreases as you climb up, reaching for higher returns. Fixed income is the broad category of investments that pay interest for money borrowed, and it is mostly bonds. Sometimes the words are used interchangeably, and for now, we’ll do that.

Standing on the ground is the same as being un-invested or “out of the markets.” It’s the money sitting in your checking or savings accounts. This money is for paying the bills and your emergency reserves (3 to 12 times your monthly bills). In savings, you’re most likely keeping pace with inflation, while the checking should be just the money you need to pay those bills.

Getting on the first rung of the ladder, where the base is still very wide, is mostly bonds. In our framework, it’s called Income with Capital Preservation (IwP) and it’s 80% bonds with just 20% stocks. You’re on the ladder, so there is some risk, but it’s only one step off the ground. This low on the ladder you’re not getting very high, but it works for getting the garland around the top of the garage door. Likewise, this investment objective should be used for the money you’ll need perhaps next year, or when your circumstances require stability over growth.

I get the most benefit from the next few rungs of the ladder. I rarely go higher than I need to reach my goals, and in that I maintain a wide base of fixed income. But as the goals get higher, or farther into the future, it’s important climb the ladder, increasing our investments in stocks, because stocks can make a lot more money than bonds over time. Remember, they come with more risk and to get better returns you must take more risk.
So the next three rungs of the ladder progress from Income with Growth (40% stocks to 60% bonds), Growth with Income (60/40), and Growth (80/20). Growth with Income is the most frequently cited investment objective. You’ll hear it referred to as the “traditional 60/40 portfolio” or a “balanced” portfolio. With 60% invested in stocks, the account mainly aims for long-term growth. But it’s still only three steps, halfway up the ladder. It is still wide; there’s still a lot of bonds providing stability. This is the most frequently preferred portfolio for people drawing from the accounts during retirement.

The top two rungs of the ladder, steps four and five, are reserved for the long reach. At number four (Growth or 80/20), there’s still a bit of ladder above my feet, against which I can brace my knees, but there’s no place to hold on with my hands. On the fifth step, (Aggressive Growth – all stocks), there’s no bracing, only the top platform remains above me. When I was younger, I’d often work on this step. I’m a bit more cautious now and find another solution.

Unquestionably, I can get to more of the lights from the top two rungs, and likewise, people fully-invested for the long run, for the future, should be in mostly stocks, 80% or higher, depending on their comfort level.

By the way, that top platform is never recommended for standing, but it can be useful, like when I need to get into the attic. It’s very unstable, and in our analogy it represents speculative investments, the kind of investments where you can lose everything. Think of the hot tip your neighbor gives you, or worse, the investment scheme that sounds too good to be true. They usually are. The bottom line with speculative investments is don’t put more into them than you can afford to lose.

Your Enduring Wealth Advisor® will help construct an appropriate account investment objective, based on your needs and goals.

Research and development of this article included the use of artificial intelligence tools.