Risk is a part of our every day lives. We encounter it in many different forms with health and financial risks probably being the biggest risks we face. We purchase insurance policies to help mitigate many of the risks we face, providing protection for ourselves and for our loved ones. Managing risk is a critical element to our long-term well-being and livelihood.
As a wealth manager, I have a keen interest in financial risk. In particular, I’m focused on helping my clients identify, acknowledge and manage the risks they face in their financial lives. Truth be told, financial and health risks are intertwined given the potential devastating impacts major/chronic health events can have on our financial sustainability. Most of us understand the importance of health insurance, auto insurance and homeowner’s insurance. We’ve all experienced or know someone who has experienced a claim on an insurance policy that they were glad to have at the time of an incident.
Investment risk is generally not as greatly appreciated. Our emotions play a substantially larger role in managing investment risk than they do with the previously mentioned insurance policies. Those policies provide protection from catastrophes, or downside risk. Investment risk is unique in that it has upside and downside elements. The allure of making a lot of money is often too great for many of us to resist. We get caught up in the hype at the time and become risk-seekers, often taking far greater risk than we should, or need to, at a time when we should probably be considering reducing risk. We experience the opposite when sentiment is negative, and everyone is telling us the stock market is never going to go up again. In these instances, our innate risk inversion tendencies take control, and we end up taking far less risk than we should even though it probably is the right time to increase the amount of risk we take.
So, how much risk should you take? Several factors are taken into consideration in answering this question. Your time horizon, your asset levels, your liabilities and your future commitments all need to be taken into consideration together to determine your ability to take risk.
There’s another equally important, if not more important, factor to consider. Your willingness to take risk. Sometimes our willingness to take risk is lower than our ability to do so. Other times our willingness to take risk is higher than our ability. And sometimes we are in the “just right” zone where our ability and willingness to take risk actually match. The mismatches are the most dangerous situations as they can lead to an impairment of our ability to grow and/or protect our assets to secure our financial futures.
Reconciling these mismatches is an important part of what I do. I need to ensure clients understand and properly manage the risks they face so they can achieve their life and financial objectives. Imagine you were underinvested and didn’t grow your investment account as much as needed to retire, requiring you to work longer or to reduce your standard of living. Alternatively, imagine a scenario where you have sufficient assets to cover retirement, but you experience a substantial loss close to retirement due to excessive risk in your portfolio, again requiring you to work longer than desired or to unwillingly reduce your standard of living. Unfortunately, and sadly, situations like these do happen. While it might feel like it at times, stocks don’t always go up. Over the long run stocks have shown they go up but we don’t get to pick when they’re up and when they’re down. Our investment portfolios and retirement dates are at the mercy of a complex system that no individual can control.
To determine how much risk you should take, you should rely upon quantitative and qualitative analysis and variables, including those mentioned previously, to help you find your sweet spot so you can end up where you want to be. From there, gaining exposure to the right level of risk is a whole other exercise requiring an understanding of asset classes and their relationships to one another and their risk and return profiles. None of this happens by accident but by deliberate effort and vigilance. Be sure you understand your personal risk profile and that your investment portfolio is exposed to the appropriate level of risk.