Our Complicated Relationship with Risk

“What the imagination can’t conjure, reality delivers with a shrug.”
Trumbo (vo)

Whether it’s the recent disasters by severe weather in Australia, a potential June “Brexit” from the European Union, or uncertainty surrounding this year’s US election process, there is plenty of risk to go around as we head towards another summer.

A client recently asked me what impact the presidential election will have on the stock markets. I don’t know. In fact, I don’t think anyone can know for certain.

It got me thinking though. Given all the turmoil in today’s world, is investing riskier than it used to be? Not in my experience. If there is a “normal” constant in our world, it is risk. We are assured by Saint Peter that cycles are inevitable. “…For ever since our ancestors died, all things have continued as they were from the beginning of creation.” Besides, investors often love and hate risk in a messed up, crazy relationship. How so? Let us count the ways.

One: Underestimating Risk.
It’s one thing when we imagine risk and its potential impact on our lives and our investments. It’s quite another when it really happens. There are several ways to help us understand our relationship with risk and determine what are tolerance for it is. None are perfect. The best way is to live it and record your feelings while you experience it. And, if you are comfortable with a certain level, take some more risk. No more, of course, than you can afford.

In investing, underestimating risk can trick you into believing that you can tolerate far more of it than you actually can. As financial columnist Chuck Jaffe has wryly observed: “[A] common mindset is ‘I can accept risks; I just don’t want to lose any money.’”

Unfortunately, we can’t have it both ways. When the risky event actually happens (only known in hindsight), if you panic and sell, it’s usually at a substantial loss. If you manage to hold firm despite your doubts, you may be okay in the end, but it might inflict far more emotional distress than is necessary for achieving your financial goals. Who needs that? Saint Peter reminds us not to be anxious for anything.

Two: Overestimating Risk.
On the other hand, we also see investors overestimate risk and being uncertain. We humans tend to be loss-averse (as first described by Nobel Laureate Daniel Kahneman and his colleague Amos Tversky), which means we’ll exaggerate and go well out of our way to avoid financial risk – even when it means sacrificing a greater likelihood for potential reward.

This summer already is destined to deliver plenty of uncertain outcomes.
• Presidential election. Especially stark contrasts with our presidential candidates. The winner will likely, as most US president’s do, set the tone for the country, if not the world.
• Brexit. Uncertainly surrounding the June 23rd vote could significantly impact the Euro and financial markets around the world. Recall the hoopla surrounding the recent Scottish independence vote.
• Middle East. The unrest tends to be normal with Israel, Iran, Saudi Arabia, etc… as the world leaders search for possible peace.
• Energy costs and oil prices. With the middle east, Russia, and the US each acting in their own best interest to satisfy the world’s demand, prices will continue go up and down to varying degrees.
• North Korea. Their quest for nuclear power and continued leadership questions will continue to pop into the news on a regular basis.

Not to downplay these events or minimize the impact these events have on your personal wealth, but you get the idea. We’ve always had these troublesome events and the world seems to continue as before. The markets will price in the ebbs and flows of new news much more quickly than anyone can trade on them with consistent profitability.

So it’s a problem if you overestimate the lasting impact that this form of risk is expected to have on your wealth.

Three: Misunderstanding Risk.
Especially when colored by our risk-averse, fight-or-flight instincts, it may seem important to react to current financial challenges by taking some sort of action.

Instead, once you’ve built a globally diversified, carefully allocated portfolio that reflects your personal goals and risk tolerances, it’s usually best to ignore both the good and bad news that is unfolding each day. I also ignore the talking heads on Sunday morning. This makes more sense when you understand the role that investment risks play in helping or hindering your overall investment experience. There are two, broadly different kinds of risks that investors face.

Avoidable Concentrated Risks – Concentrated risks are the kind we’ve been describing so far – the ones that wreak havoc on particular stocks or bonds, sectors or specific markets. In the science of investing, concentrated risks are considered avoidable. They still happen, but you can dramatically minimize their impact on your investments by diversifying your holdings widely and globally. When some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with other, unaffected holdings. When one part of your portfolio goes down, you can be assured that another part is more likely to go down. Of course, sometimes we don’t like that diversification works because usually when something is going up, something else is probably going down.

Unavoidable Market Risks – In the big picture, market risks are those you face by investing in capital markets in any way, shape, or form. If you stuff your cash in your mattress, it will still be there the next time your look. (Doing so however, you invited another type of risk into your life; inflation risk.) Alternatively, should you invest in the markets, Bam! You’ve assumed market-wide risk that cannot be “diversified away.”

I’ve had a number of new clients come to me being frustrated with the dilemma of;

  1. Not want to risk their pot of money because they are “afraid to lose it.” and
  2. Frustrated with their money “sitting in the bank earning nothing.” Either way, they assume risk.

My questions usually are around which risk they are more comfortable with.

Four: Mistreating Risk.
It’s a delicate balance, a mind game we must play with ourselves.We don’t want to overestimate the impact of avoidable, concentrated risks. Nor do we want to underestimate the far-reaching market risks involved. As our emotions move between the extremes of fear and greed, we must not miscalculate. If we assume the unavoidable market risk, we may lose in the short-run. If we avoid all market risk, we will lose the long-term growth. Those of us who stay invested when market risks are on the rise (as markets fall) are better positioned to be compensated for their loyalty with higher expected returns.

In many ways, managing your investments is about managing the risks involved. Properly used, investment risk can be a powerful tool in your effort to build wealth. Improperly used, it can be an equally powerful tool with which you can injure yourself. Either way, don’t be surprised when it routinely challenges your investment resolve.

What are the steps toward a healthy relationship with financial risks and rewards? Respect and manage return-generating market risks. Understand what risks you can assume. Avoid responding to toxic, concentrated risks. As I’ve always stated in one of my guiding money principles, “take prudent risks.”

Be careful out there,
Dan

To read the PDF version click here; Our Complicated Relationship with Risk