How well do you really understand risk? As a financial planner helping clients to invest their life savings appropriately, I know a thing or two about risk.
What I have found over the years is that people generally cannot measure, assess, and/or address risk in a manner that makes logical sense. I imagine that if Spock from Star Trek was a client, he would be one of the very few to make rational decisions on his various “financial and life” risks. However, Spock was a fictional character who lacked a human soul (he was a Vulcan), and therefore made calculated decisions without emotion.
A dangerous comfort zone is one that is consumed by complacency…or doing nothing…or taking the easy way out. A simple example is not getting off of the couch to lock the front door when a known prowler is in the neighborhood. The couch is comfortable, you are tired, and your favorite show is on. You don’t want to get up, so you just “hope” that the prowler doesn’t try your front door knob. Deep down inside, you know that right thing to do requires work and effort. But the easy thing to do is…well…the easy way out.
Ironically, most people take a lot of risk without even being aware of it. Swimming on a lake, taking a cruise, flying in a plane, crossing the street, riding a bike, eating Chinese take-out (not really, but possibly), hanging Christmas lights, frying bacon; these all have risks, and some of them are seriously risky.
But the list goes on and on. Most people don’t think about it because these activities have performed so many times without mishap that it becomes mundane…or part of their comfort zone.
So let’s shift gears and talk about investments…the subject that people “always” seem to associate with risk. Investments, and the risks associated with them, require a basic understanding of why there is a potential reward for the risk taken. In the investment world, this is known as a “risk adjusted return.” For building a portfolio with any given amount of risk, the returns one could expect ‘should’ be commensurate with the risk one assumes.
According to investment managers, risk is typically defined as anything not guaranteed by the government—such as a 10-year Note or Treasury Bill…also known as the “Risk Free Rate.”
The Flip Side–
Now, if you looked at risk in a contrasting view, you might see it in a dimension that most investors do not consider: the risk of NOT taking risk. What?? I’ll repeat it… “The risk of NOT taking risk!” This concept is a difficult but very real threat to many investors.
As an example: If you wanted to take withdrawals of $40,000 per year from your retirement account beginning at age 65 and in good health, and absolutely needed this amount to last throughout your lifetime (your unknown death age being between age 65 and 110) you might need to start with $1,000,000 in your account. This is assuming that you feel a 4% withdrawal rate is prudent.
But what If you wanted a guaranteed (or known return to invest your retirement savings into because you don’t like taking investment risk), and with all of your contributions and compounding interest over your earnings years until retirement you could only save and grow to $600,000 (because you were invested in a hypothetical fixed 3% guaranteed investment)? You would have just locked in a guarantee that you would NOT have enough money to draw from in retirement—assuming you needed that $40,000 per year income.
This detriment would be caused from NOT taking enough investment risk. And in this case, you would have ensured that you will have to reduce your lifestyle and expenses to adjust to your lower income.
Nobody wants to lose their hard earned savings. The pain of losing money hurts many multiples worse than the euphoria of winning/earning/growing it. Yet people generally want to be rewarded without taking risk. This is simply not possible without a whole bunch of luck and/or cheating the system. By assuming ‘some’ investment risk you are at least giving yourself “a chance” to have enough money to retire on–versus a zero chance.
My point is this: If risk was not balanced with a commensurate level of reward, nobody would take it. Not even our Star Trek friend ‘Spock.’ That is not to say that by taking risk, you are always rewarded—you’re not.
But we live in a world where absolutes and guarantees can (and do) seal the fate of decision makers too fearful of even the smallest amount risk. So think about that next time you take that next job interview, fly out to see your friend, or step aboard a ship. Your risk tolerance is a major determining factor of your wealth (or opportunity) now, and in the future.
As always, I am working to find a better way to gauge my clients’ risk tolerance. I don’t feel that typical boiler-plate questionnaires do a good enough job to gauge one’s aversion to risk…as there is no immediate ramifications for answering a risk questionnaire one way or another.
People tend to answer questions in a manner that represents how they ‘want to be,’ but not how they ‘are.’ It is then my job to work through this emotional and psychological challenge with my investors so they can understand in real dollars how purchasing power, potential loss, and future income is affected by their assumption or aversion to risk.
To schedule an appointment to gauge your risk tolerance, call my office at (818) 249-4984. I’ll make it an educational and entertaining process we can both learn from.