You’re already pretty smart, but let’s go for even smarter! Our Motley Fool cast is here to help you understand some common and not-so-common investing terms, so that you can be more fun at cocktail parties — and more importantly, be a better investor! Check out The Motley Fool’s dictionary of financial terms for lots more definitions.
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This video was recorded on Oct. 16, 2024.
David Gardner: Discount rate, misery index, cash from operations, customer acquisition cost, spiffy-pop. Each of these represent intermediate level terms that most serious investors know, and most people who are not serious investors do not know. Well, I’m inviting on three serious investors this week Motley Fool advisors and analysts, all in order to help teach the rest of us some new terms, terms like the ones I let off with, each of which has been covered in past episodes of this week’s recurring series, Gotta Know The Lingo. This week it’s Volume 6. Some simple terms, some more advanced all we think you need to know, drawn from investing in business technology. Understanding these terms and the concepts behind them will enable you to become smarter about the game of investing. Smarter which in my experience leads to happier and richer over time. Or maybe you already know these terms, in which case, I have a scoring system, and you can score yourself this week. It’s Volume 6 of Gotta Know The Lingo, welcoming in, Amanda Kish, Andy Cross, and Sanmeet Deo, to teach you and me this week, only on Rule Breaker Investing.
Welcome back to Rule Breaker Investing. It’s Gotta Know The Lingo Volume 6. The purpose of this series is to look at some of the terms that you might hear about. Headlines, maybe, but not fully understand from business, accounting, investing, and sometimes technology, as well, some new oncoming terms to get you thinking about the language of investing, business, and sometimes life to get you smarter about these concepts. We’re about to do Volume 6. I’m going to be welcoming on Amanda Kish, Andy Cross, and Sanmeet Deo to share three simple terms, and then three advanced terms. I’ll talk about the scoring system for those in just a second.
But let me mention next week. Get ready from some scary stories. It’s that time of year. A Rule Breaker Investing podcast tradition is to have my good friend, longtime Motley Fool advisor, Robert Brokamp on for financial horror stories Volume 3. Bro will once again be here to share true crime. Well, often, criminal stories around money and investing, Ponzi schemes, fraud, scary, bad financial advisors. It’s our once a year horror show aptly timed for the week before Halloween. Circle your calendar. Make a plan to join us next week. Be afraid. Be very afraid. I mentioned the scoring system, just about to bring on Amanda, Andy and Sanmeet, but let me make it clear how you can score yourself listening to this week’s podcast.
We have six terms for you, six that we’re going to share this week and illustrate for you at the end. I’m going to ask you dear listener quietly to think, did I learn anything from these Fools? If you feel like you didn’t learn anything for a given term, your five minutes or so were wasted by that particular term, the score would be zero because you learned zero, and we were zeros. If on the other hand, you thought that was helpful. Maybe you did know the term or, hey, I knew the term, but they made me laugh. Give yourself a plus one. Finally, if as Amanda or Andy or Sanmeet present their terms with their illustrations, if you find yourself delighted, not just by the quality of the learning, but maybe you got to smile along with it. If you really enjoyed it, give yourself a plus two. That is the scoring system for Gotta Know The Lingo. Without further ado, let’s get started. Amanda Kish, welcome to the Rule Breaker Investing podcast. A long time Fool, Amanda, I can’t believe this is the first time you’ve been on, but here you are.
Amanda Kish: Better late than never. Glad to be here.
David Gardner: Amanda Kish is the Fool’s financial planning team lead and is on a mission to ensure every Fool capital F. I might even say small f. To every Fool has a plan in place to help them manage risk and achieve their financial goals. In her spare time, Amanda, enjoys singing and acting in local community theater productions. Amanda anything on tap right now.
Amanda Kish: Yes, I actually I’m currently in production for a show that I’m doing. It’s a little different Halloween themed, Brides of Dracula show. We’ll be opening very shortly in another week, so looking forward to that very on theme.
David Gardner: Fantastic. Speaking of on theme, I think we have to have an ice breaker question for each of our guests this week. You get to go first Amanda. What’s been a go to Halloween costume for you over the years? Or this is a two part. You can pick your favorite here, pick your poison. Go to Halloween costume, or what’s a financial term that you wish you’d known prior to adulthood?
Amanda Kish: Well, this is easy for me. Halloween’s one of my favorite holidays. I dress up most years, so I’ll have to take that question. I’ll say I am a huge Star Wars fan, so, especially the Sequel Trilogy. In the past nine years, I have dressed up as many different characters from that universe, had a lot of fun doing that.
David Gardner: Amanda, I’m sure, I have to imagine Princess Leia at some point, I can imagine a number of who haven’t you dressed up as that you still might in future at some point?
Amanda Kish: I think I would like to do a female version of Kylo Ren.
David Gardner: Very nice. We look forward to that, but even more, did you say the Brides of?
Amanda Kish: Brides of Dracula.
David Gardner: Dracula. Good luck with that. Thank you for joining us for this episode, and let’s next introduce Andy Cross. Andy welcome.
Andy Cross: Hi David.
David Gardner: Andy Cross is the Motley Fool’s Chief Investment Officer. He works on Stock Advisor and alongside Tom Gardner on the services that he manages. Currently, Andy is trying to work his way through some classic literature that he never read as a student. Andy I’m not even going to say long suffering Phillies fan, ’cause the Phillies has been pretty good in recent years, but you are a suffering Phillies fan, and who you’re now cheering on in Major League Baseball?
Andy Cross: I’m cheering for the Guardians. My brother-in-law and my wife are from Ohio, and they’re both big Guardian fans, so I’m cheering for the Cleveland team.
David Gardner: I’ll cheer along with you. Plus it’s always fun to cheer against the Yankees, which is I think what most of the world does, even though those Yankees fans often get theirs and then some. Andy, I’m curious what are you reading right now?
Andy Cross: Currently right now I’m reading Moby-Dick. I finished Adventures of Huckleberry Finn, The Old Man and the Sea, and I’m almost finally finished with the Odyssey. It’s been a slugfest for me to get through the Odyssey just because I start and stop, start and stop.
David Gardner: That’s fantastic. Was there a catalytic moment that convinced you you should go on this literature adventure some years ago? I know, these are things that you feel like you missed in school. We all missed lots of stuff in school. You can’t touch them all.
Andy Cross: David when my daughter started middle school, and I started thinking about the books that she would be reading, and I came across a copy of Fahrenheit 451 just this summer, and completely coincidentally, they are reading that this year in seventh grade. I’m excited to actually talk through that with her as they finish reading it. But that was really the catalyst. I realized she might be reading so many of these books and as a more math and science focused person, but has a real appreciation of literature. It’s just something that I never really jumped onto as much. I’m trying to make up for the last time, David.
David Gardner: What a dad. I haven’t read Fahrenheit 451 myself. I obviously need to read that too. Andy that’s great. Well, welcome back. Let me introduce the third member of our Motley trio this week, Sanmeet Deo. Sanmeet, great to have you back. Sanmeet works as an analyst on the Trends scorecard, Hidden Gems 2023 portfolio, and he manages the showdown Resilient Growth plus portfolio. Outside of work, Sanmeet, you enjoy training and competing in kickboxing. I guess we have to talk about our sports teams here. Why not? Cheering on your number one rank Texas Longhorns football team. Sanmeet, welcome back.
Sanmeet Deo: Thanks David for having me.
David Gardner: Well, we’ve got our six terms, but before we get started, Andy and Sanmeet, I have to ask you the question that Amanda has already bravely taken on. Let me turn to you Andy. What’s been a go to Halloween costume for you over the years or a financial term you wish you’d known prior to adulthood?
Andy Cross: Like Amanda I’m going to go with the former question. David I think it is a lot more fun for around the holiday season this time, the Halloween season. I have two actually. One of the literature I have read repeatedly is Sherlock Holmes. I’m a big Sherlock Holmes fan. That is a very easy one, my wife bought me the costume. I have that more recently. It’s been Albus Dumbledore and I have a costume when the whole family dressed and Harry Potter attired during one of the COVID years. It was also during the election year. I have a great picture of me dropping off my mail in ballot, dressed fully in my Dumbledore gear as we were getting ready to go to boo in the zoo down at the Washington Zoo. As I dropped in the ballot, I just pointed my wand at the ballot boxers to make sure it got in securely as Albus Dumbledore, those are my two.
David Gardner: That’s great. A nice thing about dressing was Dumbledore is as we age, Andy and you and I first got to know each other when the Motley Fool got started in the ’90s, we did look younger than, but when you’re Albus Dumbledore every year, you’re the same age.
Andy Cross: That is true and that’s one thing I do like about Professor Dumbledore.
David Gardner: Among many others, Sanmeet which question would you like to answer and what’s your answer?
Sanmeet Deo: I think I’ll answer the Halloween one as well.
David Gardner: Why not?
Sanmeet Deo: Usually I’ve been a massive Marvel superhero fan comic book fan. Dressing up as Ironman or back when my younger years, dressing up as Spider Man or one of the popular comic book characters is always fun and pretending like, you’re a superhero is always a blast.
David Gardner: Do you have plans this year?
Sanmeet Deo: No plans this year. The only plans is my kids are going to go off. They’re old enough to trick-or-treat with their own friends.
David Gardner: Coming of age moment.
Sanmeet Deo: You’ll probably just enjoy the quiet time.
David Gardner: Let’s hope it’s fine. If there is mischievous as we were left to our lonesome, it could be a busier Halloween than you and your wife are expecting. Sanmeet before we get started, I know of your interesting kickboxing, which of the Marvel superheroes has the best moves?
Sanmeet Deo: I would say Black Widow, because with my phantom of martial arts. She’s the most intense with those fight sequences. She flips people with their legs and is jumping around. It’s pretty impressive.
David Gardner: Thank you for that. Now, let’s get started. Amanda, I want to turn to you first. Each of my Motley Fool advisors here has a simpler term. It’s going to be a Motley ray. I don’t even know what’s coming. Amanda Kish, what is your term Number 1 for this week’s Gotta Know The Lingo?
Amanda Kish: Absolutely. The first term that I want to talk about is risk capacity.
David Gardner: Risk capacity?
Amanda Kish: Yes, risk capacity. This relates to how much risk an investor can take on without jeopardizing their ability to meet their financial goals. It’s important because this is different from risk tolerance. Typically when we talk about risk in this business, you hear the phrase risk tolerance, and that refers to how an investor feels about taking risk. It’s more emotions based. How did you feel during the last market drop? Did you think about selling? Do you know what your sleep number is? How do you sleep at night when the market is volatile? Risk tolerance is more of a more subjective concept that measures an investor’s emotional comfort level with uncertainty and volatility.
Now in comparison, risk capacity is a more objective and directly measurable concept. It focuses on exactly how much risk an investor can take. To be clear when we’re talking about risk here we’re talking about downside risk or the risk of market losses for practical purposes. How much risk can an investor actually take on or absorb before they won’t be able to achieve one or more specific financial goals that they may have? The problem can arise when an investor’s risk tolerance and risk capacity don’t align. For example we may have someone who is very comfortable with volatility, and they’re willing to take those short term declines, or short term hits to get higher returns. But let’s say they may be close to retirement. They may have a lot of high interest debt, or they may need a big chunk of those funds in a few years for a child’s college tuition. Their risk capacity is going to be lower than their risk tolerance.
Then on the flip side of that, someone may be very risk averse, and they just can’t sleep at night when the market is down, but maybe there’s someone who they have a pension. Increasingly rare nowadays, but some people do have them, and this pension was going to cover a big chunk of their living expenses. But they also have a fairly large investment portfolio. Maybe now it’s sitting in bonds or cash equivalents, earning a lower yield. For this person, their risk capacity is likely much higher than their risk tolerance and what their current portfolio would indicate. It’s important to understand both of these aspects of risk management to get that right. Risk capacity is definitely something to have on mind.
David Gardner: Thank you. Well, risk tolerance is certainly something that I recognize. I’m sure many listeners recognize. I haven’t heard the phrase risk capacity as often. That’s just your simpler one Amanda. I know you’re going to be rocking something more complex later. But let me just say I appreciate the point that you’re making because that is more objectively measurable. It sounds like it’s more about the dollars and cents and what you can literally afford to lose, depending on what your retirement planning has been or the debt that you’re carrying, etc. I appreciate that. Let me ask you, as our financial planning team lead. I guess part of your mandate is to get people to align as closely as possible their risk tolerance with their risk capacity. Now taking calls from members and speaking to the world about this, what do you find to be the most common problem, the most common scenario where it’s sub-optimal, and it needs to be optimized. Is there a type A that you’re that it’s happen again?
Amanda Kish: I would say in having talked with members and Fools before probably the most common scenario is members who think they are much more risk tolerant than they actually are, again, talking about the emotional component of that. That it’s easy to do that in the up markets, but when markets decline, and you see the real-world experience of those declines hitting, and they’re seeing those losses, then maybe we find out that folks aren’t quite as risk tolerance as they thought they were. Their risk capacity may be higher or lower, but you have to consider both the practical and the emotional aspect of that to really get that.
David Gardner: I was going to say I hope their risk capacity exceeds their risk tolerance. That’s always a good problem to have. Well, thank you Amanda. Each of my advisors here will be providing an illustrative sentence to tie a bow on their term. Amanda Kish are you ready?
Amanda Kish: I’m ready.
David Gardner: Deliver.
Amanda Kish: In keeping with the theme of the season, I’ll say investing doesn’t have to be spooky if you carefully consider your risk capacity when building your portfolio.
David Gardner: Thank you. Not only have you taught many of us a new term, you’ve illustrated it for us in a memorable way, a sentence we can take away. I hope make it words to live by. A lot of us here at the Motley Fool are here to help you optimize your thinking, whether it’s your next stock pick or the plan that you’re making toward retirement. Thank you Amanda Kish for all the work you’re doing at the Motley Fool and for risk capacity. Let’s move on to term Number 2. I’m turning now to Andy Cross. Andy what do you have for us?
Andy Cross: Well, David is the Rule Breaker Investing podcast, so I’m going to maybe stretch the rules a little bit with my opening term here.
David Gardner: Always fair.
Andy Cross: But it is a little bit more tech business leadership, but it is heavily in the news, especially for companies that have a founder. I’m talking about founder mode. Two words founder mode. It’s a leadership approach where a company’s founder or co-founder plays a really, much more active, central role in running the business. In this mode, like a founder’s vision, style, connection with the business they helped found really influences, not just the culture, but also the direction of the operation, and especially in strategy and in product. This has really been in the news for the past year or so, started in a podcast interview with Airbnb founder and CEO Brian Chesky.
He started discussing this concept of how a founder has to really get involved in a product in the organization to be as effective as possible, not a professional manager, professional CEO, but much more from a founder, especially who is still running the business, and he advocated for this leadership approach throughout the past year. But David we really started to catch fire is in a recent post by Y Combinator, that’s a firm that helps businesses start from a venture side, and is a really inspirational and very influential VC firm and VC organization in Silicon Valley. Paul Graham from Y Combinator wrote in a blog, reflecting on what Brian had been talking about about how when companies grow, consultants and board members start to advise these founders that they need to delegate. They need to hire people so the founders can get out of the product details. Brian found that approach to be sub-optimal when it comes to Airbnb. He was inspired by Steve Jobs, actually, who got so knee-deep into the product. As Mr. Graham wrote into a blog post, that really sparked the past couple of months of conversation around this, especially through LinkedIn and other social media outlets.
Graham juxtaposed the founder mode to the manager mode, and that idea that a founder and a founder run business really has to get involved into the business and not delegate into the product and not really delegate that as much as they are often consulted from consultants or from board members. Of course, they’re great, David, they’re great, professional leaders who aren’t founders, Satya Nadella, Tim Cook at Apple. But because the Motley Fool often studies great cultures and great businesses that are founder led, I thought members might be listening and hearing to this concept and hearing more about the founder mode concept, and I thought it would just be a fun one to discuss. After all, you are founder and a co founder of the Motley Fool, and so I thought it was up to code to bring it to the show today.
David Gardner: Well, a fun topic, and Andy, thank you. Certainly, I think we do have rightly so, a little bit of a bias toward picking stocks at the Motley Fool where the founder is still in place. I can think of many of our greatest picks, things like Tesla or Amazon. Great examples of founders being at those companies many decades and adding a lot of value. But I’m glad you also pointed out some examples like Satya Nadella. I think about Lisa Sue, AMD. There’s some fantastic CEOs out there that we’re all invested in or many of us, and they’re not the founders. But I think the key is that founder mode, that mentality that you’re speaking to and that Paul Graham was speaking to, Andy, because I was having a conversation recently with all Foods founder John Mackey, who was on this podcast just a couple of months ago, and John was talking about how once the founder retires so often what happens is, you end up with a very qualified, very well spoken, smart manager of business who then takes over, but it’s often never the same at those companies. I think that passion sometimes is missing or the person who’s willing to take risks because they care so deeply about it as opposed to coming over from McKenzie Consulting or a head hunter firm and just being a very good looking CEO by many different measures, but maybe still lacking the founder mode, so it’s worth thinking about, and I’m glad you introduced that. Even though it seems integral to a lot of the things I think about, I hadn’t heard the phrase myself. I guess I’m a little bit out of the loop.
Andy Cross: Well, to be fair, I think Brian was really speaking deeply to the VC, to the venture capital industry, smaller organizations that were just starting. However, it harder to expand and Mr. Graham expanded on that. But I think it is interesting as we look at our leadership, and we look at the people who are running our businesses and focus so much on especially at public companies with so much to do where they allocate at a time, and so you might start to see and here a little bit more about founder mode for those who are founders. By the way, I don’t think it’s just for founders, but because the DNA is so tied to the company, it tends to get appropriately allocated to those who founded businesses.
David Gardner: Good one, Andy, well, that was your simpler term. I’m already looking forward to your more advanced one, but I just learned something myself. Do you have a sentence? Are you ready to rock something that will cause us indelibly to remember this moment for the rest of our lives?
Andy Cross: Gosh, I wish I could even compete.
David Gardner: You are arguably the founder of this sentence Andy.
Andy Cross: I’m much more creative than Amanda in her Halloween reference. No, all I can say is founder mode isn’t just for founders, but for all leaders to consider.
David Gardner: I like that very much, and it makes sense based on what you just shared. Thank you, Andy Cross. Let’s move on to term Number 3. We go from risk capacity to founder mode Sanmeet there. What do you have for us for Number 3?
Sanmeet Deo: This might be a term that many of you have heard, or I know many of you have experienced, and that’s shrinkflation. Shrinkflation is basically the practice mostly a consumer product goods companies where they reduce the size, the weigh or the quantity of a product while keeping the price. Efecularly, they’re increasing the price per unit without changing the sticker price. This helps business save costs as inflation has been running through the economy this past year, costs of labor and raw materials or increased costs for companies, so they either have a choice of passing on those prices to the consumers or eating them and reducing their own margins, so they thought of this new way, and a turn was actually coined by an economist, PIPA Mom grin. Shrink the products or the amount of products, keep the price.
Consumers don’t feel sticker shock. We all move along our merit a little way. But consumers are starting to really pick up on that thing and notice, another related term, I’ll add two quick ones for you today is skimflation, which is basically the same thing, but degrading, like services to save costs. If you go to a business that has services, and maybe the quality of that service isn’t as good as used to be. This is such a big problem. There’s actually a subreddit for it, where people will post pictures of products and what the sizes and the prices. One example of this chocolate that I love in spirit of Halloween, in 2016, Toblerone, which is actually one of my favorite childhood chocolates, reduced the weight of their bars from 170 grams to 150 grams for one of their sizes by spacing the chocolate out. I’ve ever seen the Toblerone. It’s very famous for their triangular shaped chocolate.
David Gardner: We all have.
Sanmeet Deo: What they did is basically spaced it out. Now, I don’t know how people would not notice this. I used to enjoy just breaking off each little piece one by one and just chewing on it. They did face backlash in the reverse course, so shrinkflation is something that many of us have experienced over the past year or more with inflation. It’s been around in the past too, but just another trick that companies are using to save on their costs and improve and keep their margins.
David Gardner: A good example is Toblerone. I appreciate the Toblerone example. Just the other day, I won’t name the brand of Granola Bar, but I was turning to my wife going, this feels a little smaller than it was before. But it made me wonder, is there any beyond a subreddit? Is there any magnet website where it’s officially being listed, the weights and costs of consumer products? I’m guessing if there was, you would have already mentioned it.
Sanmeet Deo: No official website, but I quickly looked at that subreddit, and it’s pretty detailed.
David Gardner: I’m glad to know we’re watching out there.
Amanda Kish: I don’t know the answer to this, but I would be curious. I know we’ve probably all seen charts of stocks over time broken out between dividend payers and non dividend payers. I’d just be curious to see if there was such a thing of what the stock performance has been of companies that have engaged in shrinkflation versus those that didn’t cost them in goodwill from their customers, I’d be curious to see.
David Gardner: The first thing you need to have is awareness. There has to be a general awareness that this is a thing. Sometimes there might be an article in your local paper or a story on CNBC or the local nightly news about how Toblerone cut back. But for the most part, these feel more like one offs team. It’s hard to plus, understandably, I think probably a lot of packaged goods players did do some of this during the high years of inflation just a few years ago, so maybe it became so broad and common. The term was invented, and nobody really was keeping score. But I think it’s worth keeping score going forward.
Sanmeet Deo: It’s a consumer psychology thing. I think businesses realize that people notice the change in the price of a product first over the change in the size or the quantity of a product. It’s almost like throwing them for a loop a little bit.
David Gardner: True. It does occur to me that if that product is unhealthy and some of the packaged goods, things that I eat, processed foods are not exactly healthy, it’s actually a little bit of a gift to your health and your future if you’re eating a little bit less of that without quite noticing, so silver lining, if you will. You have an illustrative sentence in which your term will appear.
Sanmeet Deo: Well, I’m going to borrow an illustrative tweet from a person that has really suffered from this. Cookie Monster on Twitter, said, me hate shrinkflation. Me cookies are getting smaller. Guess we’re going to have to eat double the cookies.
David Gardner: That is one of the better illustrative sedatives we’ve ever had in this episodic series. Thank you, Sanmeet. I think we’re all laughing at home. Big cookie monster fans. We’re at the halfway point of this week’s podcast. We just gone through three simpler terms. A reminder for each of them now, Score yourself, will you risk capacity? Founder mode, shrinkflation. Again, if you feel like you already knew those, and we added no value to your life for that one or even all three, that would be a zero. On the other hand, if for one or more of these terms, you learned something or laughed, give yourself a plus one. Finally, if you found yourself utterly delighted, and you now see the world in a new way that you didn’t before this week’s podcast, give yourself a plus two for that one. This is a self scoring scoring system. We’re scoring ourselves at home. We hope you have a high score. Let’s now move from our simpler to our more advanced terms, and I’m going to turn back to Amanda Kish, our financial planner here at the Motley Fool, Amanda. What is your more advanced term for Gotta Know The Lingo, Volume 6.
Amanda Kish: David, my term is sequence of returns risk. If that’s a little difficult to remember, you can also think of it as order of returns risk.
David Gardner: That doesn’t even initially help me that much. But I wanted it to be complex. I wanted this to be hard to remember and hard to understand. Sequence of returns risk?
Amanda Kish: Yes.
David Gardner: But you could sub in order for sequence, and that might be easier.
Amanda Kish: If that’s helpful to remember.
David Gardner: If, keep going.
Amanda Kish: I’ll try to set a little bit of light here. A sequence of returns risk, this is the risk of negative market returns occurring at inopportune times over an investor’s lifetime journey. More specifically how, I’m going to talk about it today. It’s the risk that significant market losses occur either in the years directly before or directly after someone retires. The idea here is that negative returns early in retirement are much more detrimental to a portfolio’s longevity than a few bad years later down the road in retirement. Since portfolios tend to be right at their peak, right as someone is retiring, typically, getting a chunk taken out when it’s at the height of that market value can make it much more difficult for the portfolio to recover and continue to fund withdrawals throughout an investor’s life. It’s a case where timing really matters when it comes to down markets, and I did pull a numerical example just to give you an example of how large this effect can be, so we’ll start off with two investors with identical $1 million portfolios. They’re both withdrawing 5% or 50,000 a year.
Investor 1 gets hit with a 15% decline in Years 1 and 2 of their retirement, so right out of the gate, and then they earn 6% a year from then on out. In comparison, Investor 2 earns that same 6% until Years 10 and 11 when they get hit with that same 15% annual decline. As a result of just that timing, all else held equal, Investor 1, who had the initial hit right after retirement is projected to run out of money and deplete their portfolio entirely by Year 18. While Investor 2 still has roughly 400,000 or about 40% of the initial portfolio value left at that same point in time at Year 18. It’s very clear that when down market years occur early in retirement, it can really take a toll on your portfolio, make it difficult to recover, especially if you’re trying to maintain that same standard of living that you were trying to keep from your portfolio withdrawals.
David Gardner: That’s hard news, especially because, A, it’s true, and I appreciate the numbers and B, we have no real control over that. I guess we can control when we choose to retire. We can control a little bit that and if the market dives right as you retire, I guess the good news is you’re more able to re enter the workforce than years and years later. We do have some agency, but, Amanda, it is a really interesting and concerning thing, something to think about, especially for those at or near retirement.
Sanmeet Deo: I have a question, Amanda. This may not be answerable, or maybe you answered is how best to protect against something like that, especially when you’re in retirement, that’s got to be so psychologically damaging.
Amanda Kish: Absolutely. I think David hit on one of those questions. On tactic is being a little bit flexible around retirement age, that if you’re locked into retiring at age 60 or 65, that can put you at the mercy of what the market is doing. A second strategy is to potentially adopt a flexible or more dynamic withdrawal strategy. That’s a strategy that you withdraw more when the market is up and then less when the market is down, so you’re not drawing on already depleted assets. But I think one of the more effective ways that you can mitigate this sequence of returns risk is by employing a bucketing allocation strategy for your assets, so the key here is to keep anything that you’ll need to spend in the next couple of years entirely out of the stock market.
Here we’re talking about building up a cash cushion, maybe even the next 3-5 years of living expenses. The key is that you don’t have to sell stocks when they’re down, to fund your living expenses. Instead, you can give those stocks time to rebound and still meet your near term spending needs. Then maybe there’s a bucket with bonds for intermediate term spending, and then, of course, ones with stocks for long term capital growth. We can’t control what the market does or predict it, but we can structure a portfolio in some ways that helps mitigate a little bit of that risk.
Andy Cross: Amanda as you were giving your great example, it just got me thinking. The other side of that is why it’s so valuable to start investing as early as possible and think about those powers of compound interest because that’s really what you’re talking about, that compound interest over time, and the fact that the sooner we start getting our kids, or families, or friends involved in investing, the more time we have for that compound earning to start. The juxtaposition of toward retirement, but also with, wow, the real value where those returns, because if those returns start earlier, we have that snowball effect as Warren Buffett has called just to be able to continue to grow and grow and grow those earnings over time.
Amanda Kish: Andy, absolutely, that power of compounding is so vitally important when it comes to retirement savings. Thank you for providing me with a good segue into my sentence and how I wanted to use this vocabulary term, and it is. Besides saving early and often, one of the biggest determinants of retirement success is being able to manage sequence of returns risk. Because after all, your portfolio can’t come back from the dead.
David Gardner: Staying in theme this October. Well, Amanda, thank you. I was just mentioning to you offline earlier that when we put a label on something, it often makes that a thing for us that we can then understand, we become more aware of it. I gave the lame example of the Super Bowl effect, which, by the way, I don’t think is really real, except that at a certain point if the AFC or the NFC won the Super Bowl that supposedly boded well for the market, it only becomes a thing when we call it Super Bowl effect. But more to the point of something real and actually useful, sequence of returns risk a phrase, I’m not sure many of us knew before this week is now something that makes a lot of sense to me and something worth guarding against. Again, Amanda, thank you for term Number 4, what a rookie all star debut on this podcast, Amanda, I’m looking forward to having you back already whenever I can next find the excuse to do so. Let’s now move to Andy Cross. Andy, earlier, you brought us Founder mode. Is your more advanced term in any way related to that, or are we going a different direction?
Andy Cross: Only be related to that for a founder led insurance company, David, because I’m pivoting.
David Gardner: You’re out there, I guess.
Andy Cross: Certainly, Kinsale Capital is one of my favorite businesses in the insurance and the financial space, and I will give that as an example as I’m talking about this concept of that insurance companies study and analyst study, and if you are interested in insurance companies, which tend to be sometimes complex and require just a lot of understanding in different terms, this is a key one that you will have heard, and it’s the combined ratio, two words, combined ratio, and it’s actually David, a mathematical formula. That helps to measure the underwriting profitability and effectiveness of insurance company.
David Gardner: Term Number 5, Andy, from the insurance industry combined ratio. You’re about to throw some math down. We do that from time to time on the podcast. Let’s face it. Most podcasts are not going to go heavy in math. Otherwise, your ratings get crushed. But this podcast doesn’t care about its ratings. We’re here to learn together. Andy, throw some math at me.
Andy Cross: I don’t want to crush your ratings, David, and I love the show. Hopefully, this is very simple math, just some division and some addition. There’s two parts to the combined ratio, the loss ratio, and the expense ratio. I’ll go into both of those very quickly. The loss ratio is the percent of premiums, insurance premiums that go to pay claims during any period.
Company brings in premiums by signing up clients, and they have to pay losses, and the mathematical division of that as a percentage of the premiums is what is called the loss ratio.
David Gardner: Andy, what’s a typical loss ratio in industry wide standard?
Andy Cross: For the property and casualty insurance business, which is the largest one, it’s maybe 60-70% or so.
David Gardner: Two thirds?
Andy Cross: Something generally in that range. That’s the first part of the equation, David, the loss ratio. The second part is the expense ratio. That’s the percent of premiums that are used in operating expenses that go in to generate those premiums. It includes things like marketing costs, administration costs, employee costs.
David Gardner: Paying your employees would be an example of a key. It’s not just about paying out losses.
Andy Cross: Yes, those great Geico and Progressive commercials that we see on TV.
David Gardner: A lot of them.
Andy Cross: There’s a cost of that. That’s the expense ratio, and that somewhere runs in the 20-30% ranges depending again on the quality of the insurance company. You add those two together, David, and you get what is called the combined ratio, and it’s really relative to 100%. If an insurance company has a combined ratio of below 100%, that means they’re essentially profitable on their underwriting, and those who have it above 100% means their losses and their cost to write those premiums exceeds what they brought in in those premiums. Now, a very realistic question, David is, well, wait, how can an insurance company exist if they have a combined ratio above 100%? The answer is because they make up the difference with investments. They take the capital that comes in in premiums, so they don’t have to pay out that sits in their balance sheet, they invest that capital and they generate a return. In fact, overall, the property and casualty market in the United States runs at an underwriting loss. It runs in the 102, 103% range.
Those companies need to make those investments to generate the profitability that is represented in the insurance company. That’s the combined ratio, ideally, you want to find companies like a Progressive that runs in the 95%. You have combined ratio, or travelers maybe around 97. I mentioned Kinsale Capital, which is not a property in casualty business, it focuses on a much more niche part of the business to businesses. Their combined ratio is somewhere in the mid 70% range, so they are very astute and profitable underwriters, and that means they don’t have to go out in the risk curve too much to help generate profits with their returns, with their investments.
David Gardner: Well, Andy, if I may say, that was expertly explained. Thank you very much. Both ratios, pretty clear you add them together, and then you hope it’s not over 100%, otherwise, we’re losing money. But as you point out, even if we are losing money on operations, if you’ve got Warren Buffett, for example, managing the capital that the business is overseeing, you can actually do quite well as an insurance business, even with a poor combined ratio, but usually probably, I think you still want that combined ratio below 100, if you can manage it. It is an interesting time we live through, Andy, and you probably look at this more than I do. I spend very little time looking at insurance companies. But homeowners insurance, especially in the southeast of the United States, is becoming sometimes harder and harder to come by at all, and I know premiums are going up. There’s a lot of concern about this new world in which we live with warmer temperatures and what it does to the oceans and what it does to our weather systems. Do you have any additional bone you want to throw out here or something to teach us about the world of insurance?
Andy Cross: Well, I think I’ve said this on our various different shows. I think the insurance industry is going to go through this transformation. David, don’t forget about driverless cars. To get behind the wheel or to get into a car that is fully self driving, they got to figure out all the insurance mechanisms. Who’s at fault of an accident? Is it the company? Is it the AI? Is it business? It’s very complex, and I think with so much modeling goes on to insurance companies, they’re utilizing, they’re not known as the greatest technology companies in the world that we might think of, but there’s so much tech that goes on in that world. David, as you mentioned, climate change is having a real impact, of course, inflation was having had a huge impact and the companies were I think, rightly so, probably behind the curve and raising insurance premiums too early, but then they made up for that by having, as you mentioned, not just in the Southeast, we were talking to one of our fellow investors and was talking about how his premiums on his house that has never had any serious storm damage or anything had gone up three times in the last few years.
They made up for that insurance costs by raising those premiums, now they’re not always going to have that, but certainly it is an industry that sometimes many people don’t like to focus on it, it’s not the most comfortable thing to talk about, there’s a very real purpose for us to have insurance, and it does serve that very valuable need, and I’m glad we have companies out there that do it very effectively.
David Gardner: Well, and as you said earlier, Andy, insurance companies may not always be great at technology. They’re usually pretty good at math though. They’ve got a lot of actuaries, for example. I’m imagining AI might make them even smarter about the math of their business. It’s a very interesting world that we live in, and I’m glad that you brought combined ratio to this episode of Rule Breaker Investing. Andy, I think Shakespeare once wrote, thereby hangs a tail, but for you, thereby hangs a sentence.
Andy Cross: Well, if I was caught up with my Shakespeare, David, I’d be able to validate that quote.
David Gardner: Your business read Fahrenheit 451. You’ll get there. [laughs] Your daughter’s in middle school. We need to get to high school before you get there.
Andy Cross: I need to get her reading insurance 10Ks, apparently, or at least coding AI to read insurance 10Ks. [laughs] David, my sentence is a good combined ratio is like a very well carved beautiful pumpkin on Halloween, clean, sharp, and lighting the way to a bright and profitable future.
David Gardner: Wow. That is just a little bit of a warm fuzzy moment there. [laughs] I think it’s not just me, the counsel, my group here today, I think we all felt that in the room, Andy, and no doubt, some of our listeners at large. Thank you, Andy Cross. Appreciate that. Five down one to go. Sanmeet. Back to you, sir, now. Earlier, you brought us shrinkflation. You were generous, though. You didn’t shrink inflate your answer, you gave us skim inflation as well. What are you going to bring for your more advanced term?
Sanmeet Deo: I’m going to go in a different direction here, and I’m going to have quantum computing. This is a whole new form of computing that harnesses the principles of quantum mechanics to process information. Unlike classical computers that use bits, zeros and ones, quantum computers use quantum bits or qubits, I believe that’s pronounced, which can exist in multiple states simultaneously, a property known as superposition. Quantum computing is important because it has the potential to solve certain complex problems exponentially faster than classical computers. This could revolutionize fields such as cryptography, drug discovery, financial modeling, artificial intelligence. Just to give an example of it. Imagine you’re trying to solve a complex maze. Quantum computing would be like having a magical drone that can explore all possible paths through the maze simultaneously, potentially finding the solution much faster than certain types of extremely complex mazes.
David Gardner: Boy, we’re not going to bother paying $9 95 cents before the airline to take the maze book with us anymore. We could just do it instantaneously?
Sanmeet Deo: This is a new age of more and more advanced computing, you may have heard the term, and you may have confused it with artificial intelligence.
David Gardner: I often do confuse things. Speaking of confusing, I always found Schrodinger’s cat pretty confusing, and I think some of you will recognize this, but not all of us are into it, I was just doing a little research. Schrodinger’s cat, a thought experiment was proposed by Erwin Schrodinger, it was in 1935, to illustrate the paradoxes of quantum mechanics, a cat is placed in the sealed box with a radioactive atom, a Geiger counter, a vial of poison, and a hammer. The setup is designed so that if the radioactive atom decays a quantum event, the hammer breaks the vial of poison, killing the cat. If the atom doesn’t decay, the cat remains alive. According to the principles, here’s the key term, I’m adding one to your own term. Just like you went skim inflation earlier, I’m adding super position, which is a fundamental principle in quantum mechanics. But until someone observes the system, the atom is both decayed and not decayed, and therefore, the cat is simultaneously alive and dead, and that’s what I have to add to this week’s discussion. It’s about all the closest I can get to quantum computing is Schrodinger’s cat. But keep going because this is a very important field that a lot of us, especially the rule breakers among us are starting to look hard at.
Sanmeet Deo: Just to clarify a little bit because this is a question that quickly came to my mind is, what is the difference between quantum computing and artificial intelligence? Quantum computing is the hardware technology that aims to solve these complex problems faster than classical computers. Artificial intelligence is primarily software technology focused on creating systems that can perform tasks similar to human intelligence. In that maze example that I used earlier, an artificial intelligence robot traversing through maze, it’s like having a robot that’s already learned from prior mazes and solving mazes, and it’s using that knowledge to solve this new maze that you’re giving.
David Gardner: It’s obviously profound. I remember, those of us old enough grew up in an age where Seymour Cray was this genius in the 60s, 70s and 80s, and out came the first supercomputer. These days, I think maybe our iPhone is about as powerful as the first supercomputers were. Quantum computing looking backwards to this point from the future is going to make what we’re running on today look a little bit soft more. Quantum computers performing many calculations at once, basically, living in different places and all calculating and coming up with better answers so much more powerful than the more single track. We have a lot of parallel computing today to be clear. But this is infinite parallel. This is crazy stuff I barely understand, that’s why I’m listening to the podcast this week to learn more.
Sanmeet Deo: [laughs] I often find it as a superhero fan myself as I was tying it into my Halloween costume. I often find watching Marvel or superhero movies gives you an insight into the future because we’re all almost heading to some of the technologies we’ve imagined in those movies.
David Gardner: Reminding me Arthur C. Clarke the Futurist, one of his three Clarke’s three laws, I’ve talked about it before in this podcast. I did briefly need to [Alphabet‘s] Google it to remind myself, but any sufficiently advanced technology is indistinguishable from magic. Indeed, one of my five stock samplers done some years ago were five stocks indistinguishable from magic. Andy.
Andy Cross: David, I kid you not, I’m 100% honest on this. Just this morning on a drive to school, my older daughter had asked me about Schrodinger’s cat. I think maybe we talked about it a little bit. I was watching Oppenheimer. Somehow she surprised me, as surprising as that was just I didn’t expect to hear Schrodinger’s cat. It scared me.
David Gardner: Twice in one day?
Andy Cross: Twice in one day. [laughs] Here was her reaction as I explained to her just what the experiment was. She said, that is vile. Couldn’t he have thought of a better experiment than trying to kill a cat? [laughs] I said, well, I think maybe you’re missing the position and went into it too, and she s was like, no, he could have thought of a lot better than that.
David Gardner: [laughs] Well, and there are a lot of cat fans out there that probably don’t [inaudible] to go. They probably resent what Schrodinger intended. I will remind, I’m sure you did remind your daughter that the cat is simultaneously alive as well as dead. It’s all how you want to look at things.
Andy Cross: Exactly.
David Gardner: A good conversation with a daughter on the way to school. Thank you, Sanmeet for quantum computing. It’s a phrase that I like to keep up with technology, I try to be an early adopter relative to most people, but not relative to scientists, and often not relative to silicon. Valley, but you’re keeping us on Coron, and you’re making us curious about the future we’re living into. Do you have a sentence to really bring that home?
Sanmeet Deo: I’m hoping that one day, I’ll be able to use my quantum computer to find the ideal places to go trick or treating for the best Andy in my neighborhood.
David Gardner: [laughs] I suspect that may be sooner than we’re thinking. Something like ways for walking for Andy. [laughs] That can’t be far away. It just needs a lot of people reporting in, but then they kill it. If everyone’s like, go to Ms. Jones’ at 5:12, then Ms. Jones runs out of Andy. But appreciate that, Sanmeet. Thank you. Well, quantum computing. There you have to go to know the Lingo, Volume 6. We had six terms, just to review them in order. Risk capacity, founder mode, shrinkflation, sequence of returns risk, combined ratio, and quantum computing. I think my talented fellow Fools did indeed bring some simpler and some more advanced. How did you score at home? Remember 0, 1, or 2 for each of those. Feel free to tweet it out if you got a high score or a particularly low score.
Also, our email address [email protected] if you’d like to be part of this month’s mailbag, any reflections you have on this week’s episode. Got to know the Lingo Volume 6 would be appreciated. Well, we hope your results, dear listener, speak for themselves. Whether it was a zero, one, or two for each of our terms, we had a lot of fun bringing that to you this week. Thank you again to Amanda Kish, Andy Cross, and Sanmeet Deo. In fact, I want to give them each an opportunity for a final line. It is that baseball post season time of year, we already talked lightly about the Guardians. The Yankees and the possibility should be pointed out of a subway series happening again this year. Well, in baseball, as Hitters come up, they get their walk up music. For my analysts and my advisors, and my fellow Fools, I’m going to give them a walk offline. Let’s do it in order. Amanda Kish, thank you for being on this episode.
Amanda Kish: Thank you. It’s been my pleasure. I will say happy Halloween to everyone out there. As you’re putting your costumes on, be sure you take a few moments to prepare your financial plan for the year ahead. It’s great time of the year to do that.
David Gardner: Love that. Thank you, Amanda, thank you for your debut this week on our podcast. Although, you’ve been on lots of other Motley Fool stuff, it’s just I’ve been slow to invite what a wonderful voice and thinker you are for. Thank you. Andy Cross, your walk offline.
Andy Cross: David, it’s been a little bit of time since I’ve been on the show, so it’s been great to be back here and thank you and great to be with Sanmeet, and Amanda, and yourself, and Rick behind the glass, and I hope I will be finished with Moby-Dick by the time I come back on. [laughs] Now, it is a very large book, but my goal is to plow through as many classics as I can as well as continue to study great businesses and leaders like those who are following the founder.
David Gardner: Thank you, Andy, and really impressive. I think you’ll open some eyes out there among some parents the opportunity to go back to the classics, especially ones we missed through the eyes of our kids. Love it. Although, taken too far, that could be helicopter parenting so careful Andy Cross.
Andy Cross: [laughs] Yes, I tell you my daughter does not want that. [laughs] She is already warning me of that, David.
David Gardner: Well, it sounds scary, but that’s in keeping because it’s October. Sanmeet Deo, what is your walk offline?
Sanmeet Deo: I’ll rephrase another term from another famous celebrity figure, the Dos Equis’ Man, who says, stay thirsty, my friends. I will rephrase it into, stay curious Fools.
David Gardner: Thank you very much. That is indeed the spirit of this series, Got to know the Lingo, where we’re here to educate, especially, of course, always to amuse and enrich, as well, but to educate. We’re actually building up quite a glossary of terms, A-Z. Once you start multiplying 6*6, we’ve done 36 different. Actually, we’ve done more than that a occasionally, I would blow it out past six terms over the years on this podcast. If you enjoyed what you heard, you want to keep learning with your kid in the car or just by yourself. Google, Got to Know the Lingo Rule Breaker Investing, you’ll see our previous five episodes in this series. Again, thank you to my guests, and a reminder this coming week, it’s going to be really scary. Financial Horror Stories Volume 3 with Robert Brokamp. A week from today, be afraid, be very afraid. In the meantime, Fool on.
