As this is being written, we are at the beginning of a new year. Like all years, 2025 is likely to be full of important events—in the economy, government, politics, and the global scene. Many of these events could occur with little or no warning, and all of them are likely to have at least some effect on the financial markets and, therefore, on investors’ portfolios.
Uncertainty—and the risk that goes along with it—is impossible to eliminate. In fact, risk is an inseparable element for any investment. We are all familiar with the fundamental truth that in investing, risk and reward are the two sides of the coin involved in any investment decision or outcome. But how you view and understand risk makes a big difference, both in your state of mind and also in your eventual results as an investor.
Fearing the Worst
Polaroid, Borders Books and Music, Blockbuster, Radio Shack, Sears and Roebuck… What do these companies have in common? Once, they were all household names, representing brands and services used by millions of Americans. But today, they are all gone from the corporate landscape, or else existing in such diminished form as to be nearly irrelevant to most consumers. Those who had invested in these companies lost nearly everything when they went bankrupt. And this, of course, is what investors fear most when they think about risk: “What if my investments become worthless? What if I lose all my money?”
But this actually points to an important principle when thinking about risk in investing. While it is true that someone who invests in equities (corporate stock) runs the risk of the stock’s value going to zero, it can’t go lower than that. On the other hand, the potential for increased value is theoretically unlimited. Think, for example, about a company that started about the same time as Blockbuster: Netflix. This company, which started out as a subscription service that allowed users to order and receive movies in the mail as DVDs, but soon migrated into the expanding world of online streaming, is today worth nearly $400 billion in market capitalization, with a per-share value of over $900. The stock began trading in 2002 at a price of $15 per share. You can probably think of other stocks with a similar story: Walmart (from $16.50 at its IPO to a little over $90 today, after eleven 2-for1 stock splits), Apple ($22 in 1980, over $250 today), and many others. In other words, the risk involved with returns on equity investing is asymmetric: your potential loss is limited, but your potential gain is theoretically unlimited. To quote David Booth, founder and chairman of Dimensional Funds, “Winners can gain more than losers can lose.”
Controlling the Risk
The other important thing that many investors forget about risk is that they can control the amount of risk they’re willing to accept. For one thing, you can adjust the amount of various asset types in your portfolio, based on the amount of various types of risk you’re willing to tolerate (remember: you can’t ever completely eliminate all risk). So, those who are younger and are aiming for maximum growth during their active earning years might want to tilt their portfolio mix more toward assets that, while including a higher element of risk, also offer the potential for much higher returns. On the other hand, those approaching retirement, who are likely depending on their assets to provide a reliable income stream, might want to trim their asset mix more toward less volatility, perhaps holding a higher percentage of bonds or other, less risk-prone types.
And this brings us to the vital principle of diversification—spreading your risk across a variety of asset types, which can lessen the impact of poor or negative returns in any single type. For example, suppose an investor in the early 2000s had purchased both Blockbuster and Netflix stock, putting $1,000 in each company. While they would have lost nearly all of the $1,000 invested in Blockbuster, the Netflix investment would be worth around $831,000 today. Now, it’s unlikely that anyone buying only two stocks could be lucky (or unlucky) enough to buy exact amounts of both the best and the worst eventual performer. But imagine this same concept spread over dozens or even hundreds of companies, as with an investment in an equity mutual fund. Taking it a step farther, imagine this principle applied across a variety of equities, bonds, and other types of assets. Broad diversification is one of the investor’s best tools for reducing the risk of a disastrous loss in value.
But What about “Black Swans”?
Others might say, “Sure, but what about ‘black swan’ events like the financial crisis of 2007 or the pandemic in 2020? Nobody predicted those, but they took everything down, right?” By “black swan,” of course, we’re referring to the term popularized by Nicholas Taleb in his 2007 book, describing events that are completely unforeseen and unlike anything ever before experienced (such as actual black swans, thought not to exist until European explorers encountered them in Australia in the late 1600s).
While events like these have certainly caused losses in value, it’s important to remember that even during market drops like these, the market has never lost 100% of its value. The closest they came was during the Great Depression of the 1930s, when the stock market declined by 90% from its previous highs. More recently, during the stagflation of the 1970s, markets declined by more than 40%. During the bursting of the dot-com bubble of the early 2000s, markets lost nearly half their value. The Great Recession of 2007–09 saw the stock market decline by more than 50%. And in the “flash recession” of the COVID-19 pandemic, values dropped by almost 35%.
Perhaps more important, in each of the cases above, markets not only recovered but went on to make new highs. Of course, to some, a 20% decline in prices might seem disastrous for the portfolio. But in a properly diversified portfolio, even a steep decline in the equity markets might not represent the same loss of value for the total portfolio. For those holding roughly equal amounts of equities and fixed-income investments, a 20% drop in equities might represent only about a 10% decline in total portfolio value. In other words, broad diversification can be one of an investor’s best protections against the risk of market volatility.
Having a Plan That Fits You
All of this points to the value of having a plan in place that is designed around your unique characteristics: your ability to assume risk of various types; your resources; your stage in the investment life cycle; your priorities; your core values. At JFS Wealth Advisors, our fiduciary obligation to clients drives us to spend the amount of time with each client needed to learn your needs, your goals, your “investment personality,” and the other aspects that combine to create your individual situation. We understand that each investor’s approach to risk is unique; this helps us work with you to design a plan that places risk in the proper perspective for you. We have found that investors who have a plan in place and who remain patient and disciplined in their approach to risk will generally find success in reaching their most important long-term goals.
To learn more about how we work with investors to create individualized strategies for success, please visit our website.
