To avoid common potholes that can lead to financial ruin, it is critical to understand the role that risk plays in one’s personal finances. From my experience as a financial planner, it has become clear that many people have an overly narrow view of risk. When people think of risk, they all-too-often think in terms of how to avoid or minimize something, namely investment losses.
Taking a more holistic view, however, I try to help my clients understand that risk is not necessarily something to avoid or minimize. Sometimes I even try and help clients embrace and take on more risk. While it may seem counterintuitive, it is critical to understand that a failure to embrace risk can lead to financial disaster. This is because a myopic view of risk divorces one’s financial goals from one’s total financial picture. In other words, when risk is too narrowly defined, it can result in important financial decisions being made in a vacuum, the end result of which is that one’s financial choices become constrained and goals aren’t accomplished. To put this in practical terms, a failure to understand risk might mean that one doesn’t retire on time, college funding goals might not be met, and quality of living during retirement might deteriorate. Understanding risk is important.
One scenario that I regularly encounter is that of the retiree or prospective retiree who, because of a definition of risk that is centered on avoiding losses, invests significant sums of money in low-interest bearing investments such as CDs or other cash equivalents. The thinking behind such a decision is that these investments are “risk free” or “safe”. What this view fails to take into account, however, is that risk comes in many shapes and sizes and should not solely be associated with avoiding losses. A broader view of risk takes into account other types of risk, such as inflation risk, interest rate risk, or the risk of not accomplishing larger financial goals such as leaving behind an inheritance or retiring with a certain standard of living. Investing in really conservative investments might result in low to zero volatility, but by not keeping up with inflation, the funds are subject to significant losses due to the erosion of their purchasing power. In other words, by not keeping up with rising prices, the funds are by no means “safe”. This is because one dollar invested in such a manner will not be able to purchase a dollar’s worth of goods in the future. Earning too little of a return on one’s investments might mean that one will run out of money during retirement, a scenario that is far from “safe”.
Other scenarios could be discussed at length. For example, some keep far too much money in bonds thinking they are “less risky”. Others, perhaps armed with a short-sighted “risk tolerance” view of risk, put significant sums of money into the stock market in order to be “aggressive”, but end up taking on more risk than is necessary to achieve a stated rate of return and financial objective. A proper understanding of risk also seeks to address other risks such as property and casualty risks, liability risks (the risk of being sued), the risk of losing one’s income due to disability or loss of employment, and the risk of premature death. A holistic view of risk, then, is not merely centered on avoiding losses, but it acknowledges the many types of risk that could derail a financial plan.
Instead of avoiding risk, it is imperative to understand that risk is an essential part of living and surviving in a capitalist economy. Failing to take risk, or perhaps not taking enough of it, as odd as it may sound, could cause financial failure. How, then, should one understand risk? The CFA Institute instills into its candidates that a proper understanding of risk is all about preparation and management:
Risk management is not about minimizing risk. It is about actively understanding and embracing those risks that offer the best chance of achieving an organization’s goals with an acceptable chance of failure. Risk management is not even about predicting risks. It is about being prepared for (positive or negative) unpredictable events such that their impact would have already been quantified and considered in advance. Good risk management does not prevent losses, but constantly provides management with the knowledge and insight to navigate as efficiently as possible (in terms of taking risks) toward the goals set by the governing body. (Level I CFA Study Guide; Vol. 4, Corporate Finance, Portfolio Management & Equity; 2016, John Wiley & Sons, Inc., Hoboken, NJ; p. 107)
When analyzing risk, then, I try to help clients follow the lead of successful organizations. Successful organizations and portfolio managers do not try to avoid risk, but rather they define, quantify and manage it. In other words, it is critical to think beyond mere feelings about risk or even beliefs (which might be false), but rather, as specifically as possible, to define and measure risk. For example, dollar amounts of potential gains or losses should be included in a proper risk management strategy. One can also work with a financial planner to quantify the risk in one’s portfolio by looking at calculations such as the standard deviation and risk-adjusted returns in one’s portfolio. One should also know what goals may or may not be accomplished given various levels of risk. For example, a good risk management strategy might contain specific statements such as, “If my portfolio doesn’t generate at least x return, then I will not be able to retire by age 65,” or “By obtaining x rate of return, I will be able to leave y dollars to my grandchildren at z date,” or “If I were subject to a lawsuit that resulted in x amount of legal fees and judgments, I would still be able to reach y objective.” It is important to understand, then, that proper risk management planning does not occur in a vacuum; quantifying risk must always be done in conversation with more broadly defined personal and/or organizational objectives. It is only when risks are properly defined and quantified that they can be managed.
When it comes to personal financial planning and wealth management, this is where the help of a good financial planner is paramount. An astute financial planner is ultimately a risk manager, and she is trained to take a holistic approach to risk management. She is not merely an investment manager or stock picker, but a comprehensive wealth manager. This means she knows how a risk event in one part of a client’s estate might result in unintended consequences in other parts of a client’s estate, perhaps from a tax or liability standpoint. As a risk manager, she works closely with her clients to define all of the risks that could adversely affect her clients’ financial objectives, and then she develops with her clients a sound risk management strategy that will result in their being prepared when a risk event occurs. When others are caught off guard, her clients are prepared and able to manage risk events accordingly.