Margin of Safety Planning: How to Prepare for the Risks You Don’t See Coming

0:00Charlie Munger said if you can't react calmly to a 50 % market decline at least a few times in your life, you're not fit to be a common shareholder. And that's kind of the point. Risk isn't just price movement. There are so many different types of risks that can hurt you in different ways. So today, Andrew and I are going to kind of break that down on the main types of risk you need to worry about, give you some examples and walk you through what's most important and what you can expect when you're dealing with these types of risks. So here we go. You're tuned in to the Investing for Beginners podcast.

0:34The show for the long-term investor. We cut through the noise to focus on what works, compounding, discipline, and the conviction to buy wonderful businesses and stick with them. Your path to financial freedom start now. And welcome back to investing for beginners. My name is Steven Morris and across from me is the ever risk adverse Andrew say there. And today since we spent last episode talking a lot about like this hype around the decline of tech stocks that got Andrew and I kind of thinking like maybe we should break down some of these risks because honestly I don't want to speak for Andrew but I But we kind of feel like what they're talking about in all those articles is not really risk.

1:25It's just hype. But there are real forms of risk. And but with that being said, there are real forms of risk. Volatility is not one of them, really. It's to be expected. So that's what we're going to be diving into today.

1:43I don't know, Andrew. Like, I guess volatility is where we can start on the risk scale.

1:54I guess when I think of volatility, like, yes, it hurts sometimes, but I always look at volatility as like a temporary pain. It's like going to the gym. Actually, I think that's a great analogy, volatility in the gym. Like you go to the gym, if you go to the gym just twice in your life, like you're not going to see any growth. But if you go, you know, three, four times a week, you're going to see growth eventually. But during that time of getting gaining that growth, like it hurts, you're sore every single day. Like it literally hurts to scratch your back because your arms are so freaking sore.

2:32Not a joke. So, I mean, like, how do you look at that type of risk, if you will, and kind of temper yourself to not buy into the hype? Yeah, I mean, it's absolutely the right way to think about it. One of the things in finance that's a very commonly repeated phrase is there's no free lunch on Wall Street. And so when you look at making returns with your investments, there's no free lunch. If you want to have higher returns, you have to be okay with higher volatility. Now there's scales to that. And some people abuse that idea to just make what's basically gambles. And they try to really swing for the fences on things that are crazy risky.

3:21And that's not what we're talking about here. we're talking about if you don't want volatility, go ahead, put your money under your mattress or you can put it in the savings account. But if you want to build a wealth snowball, you're going to have to accept some volatility. And the weird thing about the volatility is it's there and then it isn't and it's there and then it isn't. But then it's like super extreme in certain years and then very common. And like, what do you mean volatility? Everything's up and to the right. So it depends what timeframe we're talking about, what's happening with the economy, what's happening in politics, what's happening with public opinion.

3:59So many factors. One thing I did find interesting, I was listening to a podcast, Invest With The Best. He was interviewing Paul Tudor Jones, legendary trader, big commodities guy, different type of investing. But what I found interesting was when he talked about in 2001 and 2002, anybody who was curious about the stock market was all doing trading, whether that's day trading or trading commodities or whatever it is. And so I always find it comical. People talk about, man, if I only had lived during the bear market of 08 or 09, or if I only had lived in the bear market of 2000, 2001, 2002, so many great businesses, I would have just bought them and held.

4:49It's like, no, actually, those times when it's the hardest to buy, it's the hardest to buy and hold because that's when the volatility is just crazy. And so people won't be talking about Mag7 or NVIDIA, like great businesses. People will be talking about volatility and like how you can be trading options or you could be using leverage. And so you just have to have a plan and you stick with it. and you especially have to stick with it through the tough times, kind of going back to the gym analogy, you don't just go when you feel good. You have to go consistently and you have to stick with it. And so it's the same with investing.

5:32If you really want to be the best stock picker, the best buy and hold investor you can be, you got to stick through it. And that means sticking through volatility. And I like the way you're approaching it. It's like volatility is okay. That's what we're signing up for. And I think that's such a great way to put your mind frame into this idea rather than getting all freaked out because the rest of the market can get freaked out. That's everybody else's jobs. Our jobs is just buy good businesses and hang on to them. Yeah, absolutely. It's all how you define it, right? And I think when we – I like how you said you got to have a plan and stick with it.

6:11And I think if you're building your plan around volatility, you're going to build the wrong plan. Totally. And so, you know, like I said, the volatility is your temporary pain. But then we got things that are permanent damage. And those are things like impairments, inflation, erosion, for selling, you know, many others which we're going to get into. And those are the things that you should have a plan for and building your plan around. And I guess the first one we'll touch on is liquidity risk. Do you have any plan or on how to deal with liquidity risk? I know that's something.

6:59Unfortunately, we're dealing with ourselves right now. um was there a plan for it or is it just something that happened i don't know if i asked that right if i didn't ask that right i'm sorry um so are you talking about like on a stock level or individual level stock level yeah on the stock level um it's so important for companies to maintain liquidity is one of those things that it's like oxygen you know like you're not thinking about the oxygen, but as soon as it's gone, that's when you need it the most. So we saw it in 2020. That was a great course refresher for everybody on what liquidity is, why it's important and why good businesses put systems in place so that we're all hoping it doesn't happen, but just in case something does happen, you have things in place.

7:55So like if you talk about first stocks, I kind of have this rough checklist that's in my head. It's really just me filling out the same spreadsheet for every stock. And I guess that works like a checklist, but I'm always checking for quick ratio and like an adjusted current ratio. So what I'm looking at is liquidity. What does a company have that's due in the next 12 months? And then how much do they have available to pay those off? And so that's current liabilities and then that's current assets. And I also like to look at what levers can they tap in case they need extra liquidity so that's usually um to use some finance accounting terms it's like a credit revolver um commercial paper some of the bigger companies have commercial paper programs um so these things companies will disclose in their financial statements how much they have available so i look at a company uh i don't know why home depot always pops in my head, but I know they have like a huge commercial paper program for whatever reason.

9:00But if I was looking at Home Depot, I would look at, okay, they have this much cash, they have this much in receivables, and then they have this much they could draw from their commercial paper program. And then, so if I look at, well, they got throw a number out there, 7 billion due in the next 12 months, I feel okay if they can pull 20 billion from a commercial paper program with the snap of a finger. So those are the kind of calculations I like to do. And I think it's important to do because every once in a while, it's not very often, but every once in a while you have a company with a liquidity crunch.

9:34And so that could end in a bankruptcy. It could also just end in like a company having to take really unfavorable terms. The equivalent of that in our real life would be like somebody who has to go into credit card debt because they don't have an emergency fund, like that kind of a thing. You're just paying more interest than you should. So that's why I like to look at that as a checkmark because it just shows that they're doing all the right things. They're blocking and tackling and it's a safer investment. Right. The next we got is concentration risk. And that one's a hard one for me because the easy argument is Warren Buffett didn't do that at all.

10:19and so what i would say like if i was talking to somebody and they they hit me with that jab my answer would to them would be you know concentration can definitely build wealth but it can wreck it just as fast if not faster so i mean you know and concentration risk is just you're buying too much of your portfolio in one single stock sector theme like you're overloading your portfolio, your entire portfolio, like, I don't know, 40 % or higher in this one specific thing. And I mean, Warren Buffett did that multiple times, did he not? Like he did that with Coke, I think. And then also with, it wasn't progressive.

11:06What's? I don't remember how much Geico ever was I know American Express I think got up to 40 % Coca-Cola Apple yeah okay well I couldn't remember exactly yeah I couldn't remember exactly what ones he did it with but I know he did it multiple times yes and you know like I mean that's like saying like you're gonna just go out with the Tampa Bay Buccaneers when Tom Brady was there and fill in for him right like that's not going to happen man like he's the go for a reason and while yes we do our best to emulate him i mean it's just too risky unless you have the the funds i would say to do it safely it's just way too risky for me anyway to to really have a heavy con uh overly burdened concentration in one sector yeah me too um i like what you said about the concentration maybe we can turn that into a tattoo kind of like what girls like to do and because that was a longer phrase so it could look like a tattoo with multiple lines like a poem that was good i watched a uh interview domadoran did recently i don't know what podcast he was on but he basically said if you're highly concentrated it's just arrogance um and warren buffett's allowed he's like earned the right to be arrogant most of the rest of us haven't so yeah you just yes it can make you a ton of money but like you said it's such a great way to just destroy wealth that it's not worth it for most people yeah absolutely so well why would you say you know if someone's just starting out or maybe you know five years into building their portfolio what what do you think a safe percentage looks like I go back to one of the things I've said since the beginning is people throw out this guideline of like 15 to 20 stocks.

13:15If you're going to be a stock picker, aim for a portfolio of 15 to 20 stocks. And so what that means is you're going to know if you're a stock picker, you're holding these for the long term. You got to know what those businesses are, what they do, who their Our competitors have to have a good sense of that. Now, it doesn't have to be something you get to tomorrow, but over time, that's the goal. I'm going to have a portfolio somewhere in that range. And there can be businesses I know, I'm confident with. They have competitive advantages. They have a moat. I bought them at a good price. Those are all the things, if you have those in place, in my mind, I mean, that's what I'm doing with my money.

13:56And I think it's a good way to go also. Definitely. What kind of time frame would you put on that? Because I know we've dealt this with subscribers in the past where they felt like they needed to get to 20 stocks tomorrow. Yeah. And it's like, hang on, just relax. It'll be OK. Like, what kind of time frame would you put on? Would you give it like two to three years or maybe even longer? Yeah, I mean, I like that idea. Some people don't. It doesn't feel immediate enough. But if your dollar costs averaging, and if you're putting in a little bit over time, and if you have a long time horizon, 10, 20, 30 years, then two years is just a blimp in that.

14:43And that gives you time to build up. Now, if you're like talking about, I'm wrangling over my 401k with six figures from an old job and, you know, it took me 10 years to build this thing. Then maybe you put that in a diversified index fund and then you build a new portfolio of every month you're adding a new stock pick. Those are just some ways to think about it. That's more practical in a way. so if somebody if somebody is bringing we'll say 500 grand and from an old 401k and they're rolling it into um their brokerage to reinvest you wouldn't suggest or i'm sorry you would suggest like getting that money doled out as quickly as possible it really depends on like your comfort level if you've never invested in the stock market and even if you were in a 401k but you didn't even realize what was going on if you've never held significant positions in the stock market before putting that entire amount in the stock market all at once could be like jumping in a cold ice bath and a cold plunge except if you chicken out of the cold plunge you could be out hundreds of thousands of dollars but if you've done cold plunges before and you know that you'll stick it out for however long as needed then yeah Do you want to dive in earlier?

16:09Because a lot can happen in a couple of years. I mean, we've seen it. I don't know if it was 2025. We had something like 20 % up in the S &P. I don't know what the exact number was, but there's been some huge jumps in the S &P 500 in single years. And that's kind of how you see the S &P kind of spurt, sprint, and then kind of take a break and then sprint again. So if you can get in as soon as you can, by all means. But if you're not comfortable yet, if you have that doubt, if you have that kind of not able to sleep at night, then maybe it's time to be more practical. I think hiring an advisor is never a bad thing if you at least do it for educational purposes.

16:53And you can always do things yourself later. But just trying to be realistic with where you are, how you behave, what your track record is. I think all of that plays a role in your how risky you really are being with their money. Yeah, I think I I think I had the right viewpoint, but the wrong action in my head, because I was thinking, you know, if you have a half a million dollars that you're rolling over, the worst thing for that money to do would be to sit. and not grow because like you said, you know, that's in my mind, it was like, that's a significant amount of money. And if the S &P does have a 20 % year again, like that's going to be huge for your portfolio.

17:44But I also like your point, which I wasn't thinking about. If you've never done this before, then you're assuming a massive amount of risk right off the cuff. So I mean, what would would like a good index fund be a decent alternative to that? Yeah, but you still run the risk of it dropping 50 % just like everything else. So the same advice stands in my mind. Yeah, that's fair. I mean, like I said, I just, I guess I had the wrong mindset around it. Have you done a cold plunge before? No, they suck. like people that do that are insane like why why like i just don't get it man like they're like oh the best thing in the world after a good hard workout in the gym's a cold shower have you ever done that it's like i would rather be waterboarded man like that is straight torture like well it's torture no living you live in indiana though i think that's a different kind of cold shower and a different kind of cold plunge joe rogan's like in austin advising people that's a different cold okay well one joe rogan is just a freak of nature anyway like the dude's like 60 and still like a beast on you know in the jiu-jitsu mat um so i mean he he's just built different man like i ain't built like him and yeah i i tried it and it was like the worst two seconds of my life and and i'm like nah no like you know hot showers have worked for me for the past 30 or 40 years i'm gonna stick with them so and it's funny because like you know me i'm really health focused um you know with what i eat and exercise and stuff so um everybody talks about how healthy it is and i'm like you know what i don't care like i'll be okay i'll be fine without it right did you do it i do it when i go visit my little brother it is like borderline spiritual when i get out i had a near-death experience the first time well it wasn't near death but i thought that was i thought i was dying yeah i mean because it's torture you you know what that is synonymous to torture that's the whole point of torture to make you feel like you're dying

20:27case in point thank you for making my point getting back on topic the next form of uh real risk i think we got to look at is credit um and i know for me in the beginning of my investing journey that was the number one thing I overlooked and it's so funny because I'm so anti-credit um not not to the point like I think credit cards are evil but like just just in general like having I try to keep credit down obviously um I I overlooked credit so much but credit is really something that can really turn a company upside down quickly. Yeah. And one of those things when I first started, I did not understand either.

21:26I had a big preference for companies that did not maintain credit. Like if a company was completely debt-free or net debt-free, I was like, this is a great business. not understanding that personal finances and businesses are completely different. And they use, like you're saying, they use credit in different ways. So a lot of businesses have used it in really great ways. And there's really good reasons why they would. We don't have to get into all those details. But if I have money trapped in Japan, maybe I borrow and leverage some credit in Japan rather than repatriating it and having extra taxes on it.

22:08That's just one example. So like any good thing, it can be abused and overused by these companies. And so we do want to monitor and we want to look at it. So there's a few good metrics you can do. A great one for beginners, just to get you started, you can look at long-term debt to equity. You just take the long-term debt, which is one line item on the balance sheet. You compare it to the shareholders' equity, that's another line item. And in general, if it's under one, that's really, really good. That's pretty good. So that could be one shortcut, one way to just double check a company's credit risk.

22:52Another one, net debt to EBITDA, a little more involved, but it's a similar thing. But you're checking how much is a company making in profits? What's their profit levels? And how does that compare to the amount of debt that they have? So anything above a 4.5, you start to get a little bit worried about it. You just, one of those things on the checklist, on the spreadsheet, make sure a company is not super highly leveraged. There's always exceptions to the rule. Real estate investment trusts or REITs, they will have much higher credit risk and much higher amounts of leverage. But that's part of their business model.

23:35not to say it makes them any more risky but that it doesn't make one re really bad if it has a a five debt debt to you but like that's pretty standard so those are all things to kind of keep in mind what's the risk what happens with credit risk when a company defaults your investment goes to zero so we don't want that and that's what we're trying to avoid and then all the same things that can happen with liquidity risk as well. A company having too much debt, they can get into issues and then that can cascade into worse problems and that can hit the stock price in many different ways. So we want safe companies, we want good companies, and we want strong companies.

24:20I think the biggest thread to pull on why you said is, I find it really interesting that you're looking intentionally for companies with no debt. And that's, I think, a common thing that a lot of people don't think about is, like you said, companies use debt way different than personal finance uses debt. And it's looked at completely different. Knowing how companies use debt, and I'm just going to explain this in case our listeners don't understand it, a company borrows money say uh tesla borrows a million dollars for whatever reason that is untaxable money so they that rather than than pull money from somewhere that they'll have to pay taxes on they're going to borrow that money and get get it for to get it tax free and that so when you talk about a company that has no debt that means that company is paying full taxes on everything that they do, which to me is also very risky because that's almost in a sense burning cash.

25:31I don't know if I'm looking at that wrong, but that's kind of how it feels. Hearing, hearing as I was listening to you say, that's why the imagery I got in my head is they're basically burning their cash because they're not taking advantage of, of the like tax implications and things like that on being able to borrow money. yeah it's a tool it's a tool right so i'm a tool you are a tool you're you're a very handy tool sometimes uh sometimes you're the other kind of tool no i'm kidding um but anyway so the the next form of risk we're going to talk about is reinvestment risk and this one kind of hits me upside the head because I never thought of reinvestment as being a risk.

26:21So can you kind of define that, Andrew, what reinvestment risk means? Yeah, this is more of like talking about an individual investor, somebody who's looking at more safe, not looking at the stock market, but looking at investing in bonds or looking at investing, I say investing, but putting money away into CDs. These kind of investments where you know exactly how much you're going to get, you know exactly when you're going to get it. You say, okay, well, what's the risk in that? So for example, let's say you put your money away in a CD. I don't know what they're paying these days, but let's say it's 5 % over, I don't know, three years or something, just throwing random numbers.

27:13If the interest rates in three years are now 10 % instead of 5%, no, I'm sorry. If they go down, so if interest rates are like 3 % in five years, now it's like, great. Now when I reinvest, I'm not going to be making as much money as I was in the past. And so it's a risk because, and again, this is like very different from like the whole stock market kind of mentality. But when you get close to retirement and you look at things like CDs, or if you have enough money to buy bonds or government bonds or whatever it may be, it is something you have to keep in mind that, you know, If I'm making a financial plan that I'm going to make 5 % of my money from now until I die, that might work for these first three years of your CD.

28:09But if interest rates change in three years and now you got to put the money back in another CD and maybe now you only earn 4%. So that's kind of what reinvestment risk is. And that's why you'll see the price of bonds change over time. That could be a whole other episode. We've done episodes on bonds, but that's why you see it change because of the interest rates. Right. And this is like Andrew said, this is mainly important for people that are retiring because you're going to want to move a lot of your risky investments or riskier investments into something safe. This guarantee that's going to keep you stable for the rest of your life.

28:51And that's why this is important. To answer your question, Andrew, they are paying 4 % right now over a 12 month term. a little bit higher for the longer term uh somewhere around seven um but that's also locking that money in for whatever that it doesn't say what the term is for that for some reason but anyway oh 60 month okay 60 month how many how many years is that five yes sir so So, wow, that's a long time. So if interest rates went up in six months and now you could have gotten 8%, but you've just locked away your money for five years. That's tough. Yeah, exactly. So you just got to keep these things in mind and be very careful.

29:49But that is very interesting. I did not know that. So you learn something new every day. the next one we talk about all the freaking time and you're probably going to roll your eyes and i say it because we talk about it so much but that's inflation um inflation is one of the number one killers of wealth uh in my opinion because people don't think about it on a day-to-day basis we're thinking about it right now because it's if we feel it but you know if you ask me about inflation when I was in my 20s and 30s, I would have been like, what? Who cares? Because I never felt inflation at all. The early 2000s and the early 20 teens, like, yeah, man, that was a great time to be alive, at least for me.

30:40So I mean, inflation is a huge risk. It destroys our purchasing power. So I guess a way to put that, you know, if inflation is going insane, kind of like it is right now, you know, I actually, I made a reference like back in the show, I watched the Goldbergs. They talk about like how expensive$200 is like, man, could you imagine like investing in the stock market back in the 80s like that would be awesome like with the money we have now that would be awesome but yeah inflation is a is a big killer that you really and i don't even like how do you factor that in and how do you plan for inflation risk andrew i i don't know if you can i mean that's if there are like all the positive reasons to be an investor and to invest One of those that's behind you that's kind of whipping the heels of your feet is inflation of like, if you don't put this money to work, it's getting less valuable over time.

31:51It's just part of life. It's part of our capitalist society. And it's the reason why the economy works, I guess. you have the growth and you have money flowing. And so as a consequence, the continued growth creates inflation. So I don't know if you can have one without the other. So it's like a necessary evil. But yeah, it can be very hard. And especially lately, it's been very, very hard. Gas prices, at least in my area, they finally come down a little bit, but who knows what happens tomorrow. Um, you know, we've seen crazy prices at the grocery stores, Costco, even it's just, it's a tough environment out there right now.

32:43Um, over the very longterm, if you average inflation out, you're looking at somewhere between two to 3 % a year over the very longterm. That's the average. But in times like this, I mean, it's definitely, it's definitely a tough, tough pressure. and you can look back at what happened in 2020 and some of the things that the Fed did to unleash all this liquidity. And as that flows into the economy, it creates a ton of growth, but also a ton of inflation. And if you're on the lower end of the economic curve, you're getting hit by inflation the most because you're not getting the growth, plus you're getting hit by inflation.

33:20So it's really tough. And I don't know if there's a great remedy other than you have to try to save and invest and increase your income if you can. And the stock market takes care of inflation because businesses are growing by nature and that's how they defeat inflation.

33:41I don't think there's any model that statistically proves inflation is necessary for an economy to grow. But I would make the argument it absolutely is, even though it sucks. Because, I mean, think about it, that inflation is what makes real estate an investment. Without inflation, you know, the house you bought for$100 ,000 would still be worth$100 ,000, you know, if you keep it in good working order in 20 years. Like inflation is what drives, it's not the only driving factor, I understand that, but it's a big driving factor into why that real estate is an investment. You know, I would say the biggest thing inflation does is it keeps deflation at bay, which is something we don't talk about a lot.