The Real Risk

0:04We're human beings who evolved over millions of years of biological history. The way that we react to risk or the risk that we respond to is immediate risk. It's seeing the yellow and the black flash of light in your peripheral vision or hearing the hiss of a snake or the roar of a lion, and you respond just like that. All right? That's the way most people perceive risk in financial markets. It's the day that the market calls falls 3 % or 4 % or when there's very bad economic news. That's not risk. That's volatility. What real risk is, is living under a bridge or eating cat food when you're old.

0:51That was Bill Bernstein, a financial theorist, neurologist, and author of numerous books, including The Four Pillars of Investing, The Intelligent Asset Allocator, and The Birth of Plenty. I'm Motley Fool producer, Matt Greer. Now, Motley Fool contributor, Rich Lumelo, and Motley Fool analyst, Buck Hartzell, recently caught up with Bernstein and talked risk, risk, reward, and financial freedom. Rich and I both have young adults, so people that are either getting ready to graduate or graduating college and got their first job. And I just had 10 of those people over at our house this weekend. And one of the questions that got asked during that conversation as we sat down is, how much do we need to save in order to be prepared and reach one day financial freedom?

1:35I don't like the word retirement because I think freedom is something different. You can do what you love. You don't need to retire and people aren't meant to sit around and watch TV on their couch and stuff. How much is a reasonable amount do you think that they need to save in order to reach their goals, Bill? Well, in recent years, I've changed my mind about this. I used to think that 15 % was enough, which is the figure that you'll see in that particular book. And 15 % is adequate if you have a relatively low income, because what will happen when you retire is you will get a very nice replacement ratio out of your Social Security.

2:15The person who has below average income or average income is going to get probably in the realm of about 50 % to 60 % replacement from Social Security. But if you're an upper income person, and for that person, 15 % is adequate. But if you're an upper income person, then Social Security may only replace 30 % or 35 % of your income, or even less, if you've got a very high income. So, that person should be saving at least 20 % of their income.

2:51Rich Lumelleau:Bill, you've written that investing is simple, but not easy. What do you think makes it so hard for most people to follow sound investing principles? Well, there's a very precise analogy for that, which is losing weight. Losing weight is simple. Exercise more, eat less. It is not easy. It is also simple to say, I'm going to invest 15 % or 20 % of my salary every month into the financial markets. It's an easy thing to say that. But when the world looks like it's crashing down around you and maybe you're losing your job, it's not such an easy thing to do. The other analogy I like to use is, If you've ever had any flight training, it's flying in a simulator.

3:36Preparing for an emergency or a crash landing in a simulator is easy. It's very non-stressful. I've done it. But doing it in the real world, unfortunately, I never had to do it, I imagine is a good deal more stressful. The financial markets are the same way. It's one thing to have a plan in a spreadsheet or in a beautiful mathematical model. It's another thing to actually execute it in real time. Yeah.

4:00Rich Lumelleau:And I guess a follow-up to that is, are there misconceptions about risk that you see from your work and your writings that persist among both amateur and professional investors? We're human beings who evolved over millions of years of biological history. The way that we react to risk or the risk that we respond to is immediate risk. It's seeing the yellow and the black flash of light in your peripheral vision or hearing the hiss of a snake or the roar of a lion. And you respond just like that. That's the way most people perceive risk in financial markets. It's the day that the market falls 3 % or 4 % or when there's very bad economic news.

4:41That's not risk. That's volatility. What real risk is, is living under a bridge or eating cat food when you're old. All right. And those are two entirely different kinds of risk. And unfortunately, people pay much more attention to the first kind of risk, the immediate risk, what I call shallow risk, than they should pay to deep risk, which is the second kind of risk, the long-term risk.

5:06Rich Lumelleau:Is there a way for investors to cultivate the discipline to do nothing during periods of market volatility? You mentioned those 3 % and 4 % down days. Obviously, three months ago, we had a 20 % correction. Obviously, you were rewarded if you just stuck. Is there a way to cultivate that discipline? Well, like everything else in life, there's theory and there's practice. The theory is to look at financial history and understand that once every three or four years, the markets fall by 20%. And once every 10 or 20 years, they fall by 50%. So, it's to have that knowledge in your knowledge bank. So, know that theory.

5:45But the theory isn't enough. The practice part of it is to actually live through it yourself and see how you respond. And people respond in different ways. There are people who are utterly impervious to falling markets and will happily invest even in the worst of markets. They find it very easy to do. I find those kinds of people are very rare. I'm not one of them myself. And there are other people who, when the markets do poorly and the world looks like it's going to end, they panic. I've known people, I've known men who risked their lives in combat and seemed to execute that very well. But on the other hand, when the markets, when their portfolio fell by 5 % or 10%, they threw up.

6:29It's very odd. Yeah. Yeah, it's funny. Even business owners, people that run their own business and they've been through swings and upturns and downturns and COVID and all this kind of stuff, and they can handle that fine. But then when they see their stocks go down 5 % or 10%, it's something that kind of blows their mind a little bit. And I'm like, some of these people are friends. I'm like, you've run your business through all kinds of downturns and things that happen. Why does it bother you? And I think it's because they feel like they're in control of their business, and they're calling the shots where there's the movements in these stocks.

7:01And I tell them, just don't watch. This This is long-term investing. If the up and down bothers you, don't look at it. Go play golf. You like that. Right? Well, as I already mentioned, I like to think about things evolutionarily. And I like to think in terms of analogies as well. And the analogy I think it's appropriate here is the skunk. All right? The skunk evolved over tens of millions of years to have a given reaction to a large predator that threatened it, which is to turn 180 degrees, lift its tail and spread. And that's very effective, but it's not effective in an environment where your major predator is a hunk of steel weighing two tons, moving 60 miles an hour.

7:44That's not the appropriate response. And that analogy to finance is precise. Trading at Schwab is now powered by Ameritrade, bringing you an expanding library of education with even more ways to sharpen your trading skills. Access new online courses, insightful webcasts, articles, engaging videos, and more, all curated just for traders. Plus, guided learning paths with content designed to fit your unique interests. No sifting to find exactly what you need so you can spend your time learning to trade brilliantly. Learn more at schwab.com slash trading. Now, I want to go towards a little bit diversification because Four Pillars was a great book that you wrote and shared a lot of great lessons for people.

8:28But one of the comments in there was, when things look the brightest, returns are typically the lowest. And when things look the darkest, returns are the highest. And so I have a question for you today. We sit here July 22nd, 2025. Where do you think we are on the brightest to darkest continuum as far as investors today? Not a lot of clouds in the sky that I can see. I mean, people are talking about power-ups and debt spiral, and the unsustainability of the Treasury market. But that's not the way people are behaving. People are behaving like everything's fine. And that's a really important concept, because in the financial markets, you are paid to bear risk and uncertainty.

9:13So, the worst things look, the lower prices have to fall in order to attract people back into the market with higher expected returns. So, the best fishing is done in the most troubled waters. And the time to be wary is when things look the brightest. Warren Buffett very famously said to be greedy when others are fearful, and fearful when others are greedy. And people look pretty greedy to me right now. Yeah, the risk trade seems to be kind of back on right now, I mean, with most people. And I'd say also, stocks are relatively expensive. And it leads me into another question. and this goes to diversification.

9:53A recent Wall Street Journal article posted that over the last decade, small-cap stocks have returned about 6.6%. That trailed large-cap stocks that returned over 13%. So, they trailed by about 7.3 % per year. And that's the widest gap that we've seen going back the whole way to 1935, as they were mentioned. That includes dividends. So, I just wonder, from an allocation standpoint today, where are you on small caps versus large caps? Can you just kind of give us, do you adjust your allocation based on how well that particular class has done or not done well the last five or 10 years? Well, my emotional, excuse me, my discipline, my intellectual discipline tells me I shouldn't do that at all.

10:41Okay. But I have to admit that my emotionality, when I see something like that, tells me, yes, I should act on it. Whatever my given allocation was to small cap stocks, say, five years ago, maybe it's a little higher now, just for that exact reason. The financial markets do have a tendency to mean revert, which is what that article by Jason Zweig talked about. Mean reversion is a relatively weak phenomenon. It's at best a 55-45 bet. But if you make enough rough 55-45 bets over the course of your lifetime, you're going to win some, you're going to lose some, but on average, you'll come out ahead.

11:19So, you know, I think that's a bet that's worth making, but don't be surprised if it doesn't work this time. Okay. So, intellectually, you say, I stick to my guns, I've had my allocation, but also you say, I might tilt a little bit more in that direction, given that recent data. And can you give for people that are listening at home, so they have an idea, what are your rough kind of allocations, would you say, in a simple form, to large cap versus small cap and, say, international and maybe bonds in there? Well, I think the typical investor is well-advised to hold the market, the total stock market.

11:56And if they want to tilt towards small cap stocks, they can do it with a small portion of that allocation, say, a quarter or at most a third of it. Understand that there are going to be long periods of time, like the last 20 years, when you're sorry you did that. So you have to be extremely patient.

12:15Rich Lumelleau:How does geopolitical risk, and I'm going to throw tariffs into that just because it's basically, we're kind of dealing with every country in the world. How does geopolitical risk influence your long-term investment strategy? Yeah, I like to channel Ken Fisher, bless his soul, who observed that he pays close attention to the headlines because he knows that if something is above the fold, that is, it's the top of the headlines. It's kind of an archaic term, I guess, showing my age. If something is above the fold, then it's already been impounded into the prices, so he knows he can ignore it. And those are the kinds of things that fit into that category.

12:53Geopolitical risk, what's the Fed's doing? Everybody knows about that stuff. It's impounded in the prices. And that's not a new observation. I think it was almost over 100 years ago that Bernard Baruch said that something that everyone knows isn't worth knowing. If it's in the paper, it's in the price, is usually what I tell people. Exactly. That's a great way to put it. Yeah. Yeah. We tend to be bottoms up here at The Fool. And so, we get a lot of questions, particularly around the tariff noise. And we can point to them and tell them, hey, in 2016, there was a similar conversation that was going on.

13:27Here's what happened then. Most of those international stocks traded down pretty significantly once the presidential election happened in 2016. And then the year afterwards, international stocks took off. I think China was the best performing, up probably over 50 % in 2016 during President Trump's first year in office. So, we can tell them the data, but it's hard because people focus on what's in the newspaper. And I'm like, if you can just keep your goalposts focused on how the business is doing in the company and pick good businesses, you're probably better off because the noise is immense that is out there.

14:04Right? Yeah. If there's one kind of data I tend to pay attention to, I do it as a negative indicator, which is you'll often hear people say, you know, country X, Y, or Z has a great economy, it's going to take off, buy its stocks. And it turns out that there's an inverse correlation there. And there are a lot of different reasons for that. But the poster child for that phenomenon is China. Over the past 30 years, economic growth in China has been through the roof, almost 10 % real over the past 30 years, every single year. And yet, over the past 30 years, Chinese stocks have been money losers.

14:43They've had terrible returns for, again, many, many different reasons. So, that's one argument that I tend to pay attention to, because it's so specious that it usually works out the opposite direction. Yeah. And, you know, I remember when the BRICS were all a big thing, and that was Brazil, Russia, India, and China, and they were the emerging growth stories. Well, I think over longer periods of time, those emerging market stocks tend to perform less than the developed world, because, as you like to say, everybody runs towards the growth, and then the multiples get bid up. But we even had some members that posted some ETFs because they wanted exposure to the growing middle class of China, which is a smart thing, right?

15:24I mean, they had huge growing middle class. But if you looked at some of the ETFs that were available for investors, most of those were investing in government-run entities in China. They were state-owned enterprises like banks and manufacturing and stuff like that. They were getting very little exposure to the rise of the Chinese consumer. So, I said, you have to be careful sometimes when you just look at some of these ETFs that think they're meeting your need. You have to understand what's in them as well. There's a more general principle, epistemological principle here, which is that narratives and stories are very misleading.

15:59We're human beings, we tell each other stories, that's how we communicate. That's a really lousy way to invest. If you're buying a story, you're very liable to have your head handed to you. What you should be looking at is the data. And what's the data? It's the valuation. You know, what kind of earnings yield are you getting? What kind of dividend yield are you getting? That's what you should be paying attention to.

16:21Rich Lumelleau:As an investor, I'm buried in data and making sense of it all is hard. That's where Claude helps me every day. I regularly give Claude a company's financial statements going back a few years and ask it to flag anything that looks like an outlier, line items moving in a way that didn't match the trend around them. It surfaced a lot of things I probably have skimmed past before. Things like expenses growing faster than revenue or margins quietly improving while the headline numbers look flat. Claude doesn't tell me what to think. It helps me see just where to look closer. That saves me time, helps me find more opportunities to invest, and more risks to avoid.

16:56Rich Lumelleau:Claude is the AI for minds that don't stop at good enough. It's the collaborator that actually understands your entire workflow and thinks with you. Whether you're debugging code at midnight or strategizing your next business move, Claude extends your thinking to tackle the problems that matter. And with Co-Work, Claude actually builds real spreadsheets with working formulas, not just a CSV dump that leaves me with 90 % of the work undone. For problems worth solving, get started with Claude at Claude.ai slash fool. That's Claude.ai slash fool. And check out Claude Pro, which includes access to all of the features mentioned in today's episode.

17:29Rich Lumelleau:Claude.ai slash fool. You've talked a lot about behavioral finance and psychological tendencies. I think investors that are trained in those tend to do better, and they protect themselves from making a lot of mistakes. So, I want to spend a little bit of time on that. I grew up, we had one investor in my household, and that was my mother. And she was probably the best investor I've ever known because she's had the ability to buy good companies and hold them for six decades. Those are companies like Apple and Microsoft and things like that. And at the end of her life, I mean, your portfolio reflected the fact that she held on to her winners.

18:05And I want to just ask you a little bit about people that are just beginning. And I've worked a lot with our interns this summer, as well as many summers before. And I've seen a difference between men and women investors. Like I said, I grew up a lifelong relationship and investing with my mother. She was very patient with her stocks. Men that I know tend not to be. They tend to want to buy and sell and trade a little bit more. I just want to know, for people that are beginning investing, and I'm talking about people that are pretty humble here, and they're scared to lose money on their first investment.

18:39They're scared to take that first leap. And I tell them, if you're great, you're going to be wrong 40 % of the time. Don't sweat it. It's fine. What do you tell those people that are a little scared to get started because they're going to buy that first investment, whether it's a stock or ETF, and afraid it's going to go down? Yeah. Before I answer that question, the first thing you talked about, the gender difference, is quite salient. Testosterone does wonderful things for muscle mass and reflex time. It does not do good things for judgment. And so, women tend to be better investors than men are.

19:15Now, as far as what you do with your first investment, you have to find out what kind person you are. And I tell people who are starting out to invest relatively conservatively, so that when they hit their first bear market, they find out what their actual risk tolerance is. So, the first investment that a person makes, I generally tell them, start with a 50-50 portfolio. And when the market goes down 50%, which is liable to happen at some point in your first 10 or 15 years of investing, then you're going to find out who you are. And if you bought more or you held on, fine, you know what to do.

19:50You're either going to keep that allocation or you're going to up your equity allocation. But if it ruins your life, maybe you should be 30-70 for the rest of your life because that may be suboptimal, but a suboptimal allocation that you can execute is better than an optimal one, a stock-heavy one that you can't execute. That was Bill Bernstein. His books include The Four Pillars of Investing. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear.

20:23All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. For The Motley Fool Money team, I'm Matt Greer. Thanks for listening, and we will see you tomorrow.

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