Even when the investing odds seem to be in your favor, it's never wise to ignore downside risk because improbable adverse scenarios do occur sometimes.
Last week on American Family Radio's Faith & Finance program, SMI's Mark Biller discussed being prepared for downside risk.
Mark and host Rob West also fielded listener questions.
To listen, click the play button below. Scroll down to read the transcript.
Faith & Finance airs weekday mornings on AFR. Different versions air weekdays on Moody Radio and CSN.
(For more radio appearances by members of the SMI team, visit our Resources page.)
Transcript
Rob West:
It's usually smarter to weigh consequences rather than chase probabilities.
Hi! I'm Rob West. Whether you're building a portfolio or mulling over a new job prospect, checking the odds of success matters, but what if even a low-odds failure could wipe you out?
Today, Mark Biller joins us to talk about how to guard against the kind of events that can ruin a financial plan and more. And then it's on to your calls at 800-525-7000. That's 800-525-7000.
This is Faith & Finance on American Family Radio — biblical wisdom for your financial journey. (opening music ends)
Well, our guest today is Mark Biller. He's executive editor at Sound Mind Investing, an underwriter of this program. He's a regular contributor and our go-to guy on the markets, and the economy, [and] building portfolios. So today, as he sticks around to answer your questions, it's a great time for you to call 800-525-7000. We'll get to them in the next segment, but now's the time to call.
Mark, great to have you back.
Mark Biller:
Thanks for having me.
Rob West:
Mark, you've got a terrific editorial called Focus on Consequences, Not Probabilities in the latest issue of Sound Mind Investing. Let's dig into that. Why does that idea matter so much?
Mark Biller:
Well, risk-taking is inevitable in investing as well as in life. But the key here, Rob, is you never want to take a risk that you don't have to take.
Probabilities deal with how likely something is to happen, but consequences deal with how bad it might be if something does happen. And that's a really important difference.
If someone tells you there's a 99% chance you'll be successful at something, well, that's the probability. And in this case, obviously it's very high. But what if that 1% chance of failure is so dramatic — like you're dead? Well, a 1% chance of ruin is still ruin.
Rob West:
Yes.
Mark Biller:
So even if the probability is really low, if the consequence is severe enough, then we really have to weigh that more heavily in our decision-making than even the high percent chance of success.
Rob West:
Yeah. Let's take that one step further and help people understand what we're talking about. You have this great example about crossing a busy street. Walk us through that.
Mark Biller:
Yeah. I think it's something that we can all relate to, right? It's the perfect example of low probability, but high consequence.
So the probability of getting hit by a truck crossing the street is low, but we all still look both ways before we cross because the consequence of getting run over by a truck is catastrophic. And so in the same way, we're just encouraging investors not to ignore the small probability of a wipeout event just because it might be statistically unlikely.
Rob West:
Give us an example of this, Mark, from the investing world.
Mark Biller:
Sure. Well, one of the most famous examples was the failure of Long-Term Capital Management, which was a really famous hedge fund back in 1998. And the reason this one really stands out, Rob, is that the brain trust behind this particular fund was just full of investing legends.
In fact, there was a famous book about this whole episode that came out after, and they titled it When Genius Failed. So the short version of the story is these were the smartest investing guys in the room. They built these amazing models that would have worked almost all the time,
But they got hit by the age-old combination of leverage and just the wrong sequence of circumstances. And it ended up wiping out the whole hedge fund. And depending on who you believe, it almost took down the whole financial system with them. So this was a classic example of "most of the time this would have worked." It was low probability of failure, but very high consequence when it did fail.
And if we're honest, looking through financial history, there are so many examples like this that it really should make us humble about how low the probability of these types of failures actually is.
Rob West:
The article that you wrote leans on the late Peter Bernstein's work. Tell us what his key insight was.
Mark Biller:
Yeah. Bernstein wrote maybe the definitive book on the history of financial risk, [titled Against the Gods]. And his key insight was that the consequences of being wrong are more important than the probabilities of being right.
So Bernstein was urging his readers — and by extension investors — to ask, if something goes wrong, how wrong can it go and how much will it matter? And so that single question really reframes the whole issue of risk from a math question to a survival question.
Rob West:
Mark, taking this then from the theoretical to the practical, let's talk about margin of safety. How can an individual investor build a margin of safety into their portfolio?
Mark Biller:
Yeah. Well, thankfully, Rob, this is where we can start to lean on these timeless biblical principles to help keep us safe. So we start with the core financial foundation that you and I often discuss, and we build that by getting out of debt and establishing an emergency savings reserve — ideally before we start putting large sums of money at risk in the markets.
Now, once we get to that investing stage, then we diversify across asset classes to manage risk. We avoid concentrated bets and especially leverage, which can permanently impair our capital. And so maintaining a margin of safety is really at its core, having the humility to acknowledge that we are fallible and we're leaving room for error instead of running every scenario at full throttle.
Rob West:
We'll continue to unpack this. We'll also talk about something called "sequence of returns risk" in just a moment. But let's head to Washington. David, you'll be our first caller. Go ahead, sir.
Caller:
(inadudible) ...and my wife is 62. We are looking at moving from the stock market to an annuity. The company I mentioned does — I don't know if I can say it on the air — does not have a cap or a participation rate. We don't need the funds to live on and have our other assets we could liquidate if absolutely needed. Each year, we can pull about 10% if needed and are aware of the tax ramifications of that. They also offer a 24% bonus that is neatly added to your balance. Please, I'm asking for advice, pros and cons to this program. And thank you, and God bless.
Rob West:
Well, thank you, David. That's very well said. Great background. Mark, how would you encourage somebody to evaluate a product like this?
Mark Biller:
Yeah. Well, I guess big picture. Annuities are very attractive because they take some of the risks of investing off the table. Usually with most annuities, you either have no downside risk or you know exactly what your downside risk is. And that's very appealing to people to be able to have that knowledge of what that worst case is.
On the downside of annuities is they are typically expensive. So they're a more expensive way to invest than some other ways. And they can be very complicated and hard to get out of too, ao that it tends to lock your money up in ways that other investments don't.
So you have kind of a — that's the general pro/con framework for annuities. Then I would say within that, every annuity's different, which is part of the difficulty in evaluating them. So you got to be really careful about exactly what your specific annuity says.
So, like in this case, just listening to David's description, one thing that jumps out to me, Rob, is if they're offering a 24% bonus at sign-up, well, why? Why are they offering that? And what is in this annuity that justifies it from the insurance company, the annuity provider's point of view, that it's worth providing this bonus to get the person to sign up? So those are the types of things that I would look at.
Generally speaking, if a person wants that security and wants an annuity, I would generally encourage them to consider maybe annuitizing a portion of their nest egg, but maybe not the whole thing. It doesn't have to be an all-or-nothing type of decision. So that's generally my approach to annuities, Rob.
Rob West:
Yeah, I love that. David, I'm confident that gives you a framework to think about this.
And just for the benefit of our listeners here, when somebody says an annuity company says they're giving you a bonus, it sounds like a 24% — in this case — investment return. It's not. Basically, what's happening here is they're allowing you to have an income-benefit bonus. So that 24% may be credited only to the income base that's used to calculate future guaranteed income. That benefit base generally isn't cash value and may only become cash value over time. There's probably some vesting schedule there.
But David, hope that helps. Thanks for your call today. We appreciate you being on the program.
Mark Biller is here today. We'll talk about consequences, not probabilities and your questions after this.
Rob West:
Thanks for joining us today on Faith & Finance here at American Family Radio. Whether you're building your portfolio or mulling over a new job prospect, checking the odds of success matters, but what if even a low-odds failure could wipe you out? That has massive implications no matter what decision you're considering, but that certainly includes your investment portfolio.
And that's what we're talking about today with Mark Biller. His article on this topic is available at soundmindinvesting.org. Just look for Focus on Consequences, Not Probabilities. Again, that website: soundmindinvesting.org.
Mark, as we've talked about, there's something that is significant for retirees, and it's a term called "sequence of returns risk." Share that with our listeners today.
Mark Biller:
Yeah. Well, Rob, that's a fancy term for a very real potential problem that retirees face. And that is that losses early in a person's retirement can deplete a portfolio so quickly that even strong returns later can't necessarily make up for it.
This turns into a little bit of a math problem where if you weren't taking withdrawals from a portfolio and you just had, say, 10 years of returns, it wouldn't matter what order those gains and losses came in. You'd get to the same result whether you had the losses early or the losses late.
But because people are taking money out of their portfolio, if you combine a big early loss with withdrawals from the portfolio, that can make it really hard for the portfolio to recover and supply enough money through the whole retirement. So because of that, planners and advisors know that this is a real risk. You have to watch out for the possibility of big losses early in retirement.
And so there are different ways that advisors and planners deal with that. And one of those is just simple diversification. You want to be well diversified so your whole portfolio isn't exposed to too much stock market risk early on.
And then there are some other strategies that can help with that too, such as holding a few years worth of spending in very low risk cash or bond type accounts, specifically so that if you run into one of these really bad markets early on, you can just use that cash balance for your withdrawals and you don't actually have to take money out of your stock market investments when the market is down substantially.
So these are just a few strategies to get through that early stage of retirement so that bad returns don't sabotage the whole long-term plan.
Rob West:
Yeah, that makes a lot of sense. Let's make this even more practical, Mark. So how can our listeners today test whether a risk is acceptable for them?
Mark Biller:
I think the biggest thing, Rob, is to focus on that worst-case scenario first. And that doesn't mean that you go through life as the pessimist looking behind every rock for the horrible thing that could happen, but you do weigh your situations and the decisions you're making by asking what is the worst-case thing that could happen here? And if the loss is significant enough that it would derail your goals or cause you sleepless nights, then that's probably a risk that you can't afford and you need to make an adjustment. And that's true even if your probability of success seems good.
Now on the other hand, if you go through that process and you weigh it and say, "What is the worst-case scenario?" and that downside seems reasonable, well, then, at that point, you can go back to the probabilities and say: "Okay, how likely is it that this downside risk that I could handle if it did materialize, well, what is my probability of that happening?"
So the probability and the consequence work together. The problem is that a lot of people will look at a high probability and just discount the terrible consequence.
And we see that a lot right now in the investing world as things like heavily leveraged products are becoming more and more popular. And some of that is people maybe not understanding what the downside risks are. But I think a lot of it is also just ignoring those downside risks and saying, "Well, the probability seems pretty good that this is going to work." And so they never go to that next step of, but what if it doesn't? What's the implication of that?
Rob West:
Yeah. Your questions for Mark Biller today — 800-525-7000. We've got just a few lines open.
Let's go to Dallas. Lou, thanks for calling. Go ahead.
Caller:
Yes. I am 88 years old, and I work a part-time job to supplement my Social Security. I've been widowed for about 20 years. I have an IRA, about $50,000 in it, and I'll have to use that when I retire from my part-time job. And my question is, is there any way that I can avoid paying taxes when I take it out for the supplement?
Rob West:
Yeah. Mark?
Mark Biller:
Well, I think a lot of that, Lou, will come down to how much money you have to withdraw from that. And if you're needing all of that income for your living expenses. If not, and if some of that, for example, was being given to your church, there are some things that can allow you to bypass your tax return with some of those withdrawals from the IRA. There's something called a qualified charitable distribution that can help with that.
But if you're needing all of the distribution for your income, then it becomes really just a math problem of what your standard deduction is and the amount of income that you have and whether that's going to be enough that any of that distribution is taxed. I mean, it technically is taxed, but because of the way the tax system is set up, you get a certain amount of buffer room before those taxes really kick in.
So those are my thoughts. Rob, do you have anything about how that would impact the Social Security specifically?
Rob West:
Yeah, it's a great question. And I mean, you would have the same thing that you have going on with your part-time income now is that as that adjusted gross income increases, more of your Social Security becomes taxable, but it doesn't sound like you'd be taking more. Perhaps you'd have less total overall income — when you get to that season, you're no longer working — so you're probably going to have the same or less in terms of taxation.
There really is no way to get that money out of the IRA without it being taxable. But to Mark's point, for 2026, the regular standard deduction is $16,100 for single filers — $32,200 for married filing jointly — and then you get an additional senior deduction of up to $6,000 per person 65 and older through 2028. So you've got some options there, I think.
The key will just be making sure you really regulate those withdrawals so you don't deplete that IRA too quickly.
But Lou, I hope that helps. Thanks for calling today. We appreciate you being on the program.
Mark, as we continue to talk about this topic here, I love this mention you have in your article about something called "Pascal's Wager." And I'd love for you to give us the quick version of that story and then show how it applies to investing.
Mark Biller:
Yeah. Well, Pascal's Wager was a 17th-century thought experiment from a French mathematician, philosopher, theologian, Blaise Pascal. Blaise was a Christian himself. He was a devout believer, but he was making this appeal on strictly logical grounds to unbelievers through the argument that he said — which was since none of us can be certain whether God exists, the safer bet is to live as though he does. That way, if you're right, the gain is infinite. You gain eternal life. And if you're wrong and there is no God, the cost is minimal.
So, in other words, Pascal all these centuries ago was giving us an example here that when outcomes are uncertain, we should be weighing the potential consequences, not just the odds. And so by giving more weight to what could go wrong, we leave ourselves plenty of margin to stay on track, even if we end up being surprised.
Rob West:
So how can someone then gauge their personal "risk tolerance" through the lens of consequences?
Mark Biller:
I think again here, Rob, we need to start with the idea of what if this doesn't turn out the way that I expect it to? What is the impact going to be if it doesn't turn out well?
So that's another way of framing this question of if it goes wrong: "How wrong could it go and how much will that matter?" And so as we apply that to our investments, there are lots of different applications.
That could be a reason that we continue to own some bond allocation, even if, for example, you don't really love bonds right now. It could also be a reason why we're not going to get too conservative in our investments early in retirement. What if the probability of living a long life and inflation being high kicks in? It may not be a high probability that we're going to have that high inflation scenario, but it's certainly not zero either. So we need to keep part of the portfolio growing to keep up with inflation.
You and I could probably trade examples like this all day long, but the main point is we just need to consider what things may be unlikely but still possible and then weigh the consequence of those scenarios.
That's a good way to determine whether various risks are acceptable or not.
Rob West:
Mark, as we continue to think about this, obviously you mentioned bonds and that just, I'm sure for a lot of listeners out there who are in this retirement season, maybe they've got that 60% in bonds. What would you say to those folks just in terms of what they might expect moving forward?
Mark Biller:
Yeah. Well, bonds have not been a very good-returning investment the last several years, the last five or six years really specifically. And that is largely due to the increase in interest rates from very low levels back around the COVID lows in 2020. As interest rates go up, bond prices fall. So total bond returns have not been good as interest rates have been going up.
And so the question for every investor is if this is likely to continue. And of course there are arguments for that and arguments against that. But generally speaking, we don't want to get too far over our skis making a bet in either direction. Our investment returns shouldn't be entirely dependent on our ability to predict things like this that are very, very difficult to predict.
And so what we do instead is we build diversified portfolios. At SMI, we have brought our bond allocations down a little bit, but we haven't gotten rid of them entirely. And so that's kind of this idea of considering a range of possibilities, considering what we think is likely, which in this case has been that interest rates have been going up. And so we've been bringing our bond allocations down a bit. And, again, we're not making a permanent adjustment there. This is more of a tactical adjustment.
And so we want to stick fairly closely to what has worked well historically, which is maybe we're not going from 60 / 40 to 100 / 0, but maybe we drop that 40% a little bit. And we've talked about how at SMI we have brought in other portfolio diversifiers like gold, like commodities, some things that can play a similar diversifying role to bonds without putting quite as much weight on a bond turnaround in interest rates and a change in the way bonds have been behaving.
Rob West:
Well, Mark, so thankful for you, my friend. I've got 30 seconds here. Just tie a bow on our conversation for today.
Mark Biller:
Yeah. Consequences are more important than probabilities. So build a margin of safety into your planning and follow those biblical principles. That's a durable foundation no matter what the market serves up next.
Rob West:
I love it. Folks, visit soundmindinvesting.org to find this article — Focus on Consequences, Not Probabilities.
While you're there, check out the Private Client group if you'd like to delegate to Mark and his team for investment management or become an SMI subscriber. The Sound Mind Investing newsletter, for more than 30 years, has helped do-it-yourself investors have a reliable, proven strategy and trustworthy guidance. All of that available at soundmindinvesting.org.
Mark, thanks for your time, sir.
Mark Biller:
Always a pleasure, Rob.
Rob West:
That's Mark Biller. I'm Rob West. Big thanks to my team today — Jim, Devin, Patty, and everybody here at FaithFi that makes this possible. If you want to support our work, go to faithfi.com/give and then come back and join us tomorrow.
We'll see you then! Bye-bye!
