Understanding Risk; Four Ways to Help Your Wealth Management Plan

There are typically three risk profiles that investors are assigned to within the financial services industry, which are conservative, moderate, and aggressive.  These categories are usually defined by an investor;

• Time Horizon - age and when you expect to need assets,
• Long-Term Goals & Expectations - views of how an investment should perform,
• Short-Term Risk Attitudes – views towards short-term volatility.

These components help to make up what is called your investment risk profile.  However, your risk profile may be very different from your risk perception.  While your risk profile may remain constant for years or even decades, your perception of risk changes with time, experience, and circumstances.

Understanding yourself is the most crucial part of the investment process when you consider putting together your wealth management plan.  Your reactions, personality traits, biases, and limitations all play a critical role in the investment and planning processes.

Let's look at the following example;

• Let's say you start saving at 30 when you sock away $500 a month.  You increase that amount by 3% each year to keep up with inflation.  Miraculously — because this is a fake retirement calculator scenario — you earn an even 7% annual return on your money yearly.  By age 60, you have roughly $830,000.  Not bad.  However, let's say you do not want to retire until age 65.  By then, your portfolio would grow to more than $1.2 million.  That means around 35% of your ending value at age 65 would come from the last five years of portfolio growth.  The pressure at that point can be intense if you are unsure what you are doing.

This example illustrates why real risk management involves creating behaviorally aware portfolios, not fancy mathematical risk measurement techniques.  The most significant risk for investors is never a black swan or a market-moving geopolitical event.  The most significant risk for investors is themselves.

Understanding Risk

Risk can be subjective, hidden, and unquantifiable.  However, at its most basic level, investment risk is the likelihood of losing money.  We have touched on the first step regarding risk, which is understanding your risk profile vs. risk perception.  The second step is recognizing when it is high.  The critical final step is controlling it.

One of the most important things you can know about investment risk is the surrounding probability and outcome.  Probable things fail to happen, and improbable things happen constantly.  Risk control is invisible in good times, especially when stock markets are skyrocketing higher and are likely to generate subpar returns.  However, good times can quickly turn into dangerous times, at which point risk control is the best route to loss avoidance.  On the other hand, risk avoidance is likely to lead to return avoidance as well.

In his article What Are You Afraid Of?, Dr. Steven Novella, an academic clinical neurologist at Yale University School of Medicine, raises the question of why so many people worry about the (statistically) wrong things.  Below are a few of his conclusions;

• Fear and anxiety are adaptive emotions, but their net effect in a sophisticated technological civilization is not always adaptive.  Unsurprisingly, I find backing up our intuitions with an analytical approach extremely helpful for a skeptic.
• Fear can be a net negative when it is hugely distorted, and fear can be manipulated by people with an agenda.  Analyzing actual probability and going through a thoughtful analysis will help put our fears into perspective and identify measures likely to be helpful rather than harmful.

While emotions can work to our benefit, they can work to our detriment, especially when handling our financial lives.  At times we may become so consumed with our fears and emotions that we do not know how to hit the stop button to reset and begin anew with a different perspective.  Here are some helpful aspects to keep in mind when considering and understanding your risk perception;

• Have a healthy respect for risk and an awareness that we do not know what the future holds,
• Insist on defensive investing while having an emphasis on avoiding pitfalls,
• Do not review your portfolio frequently.  Doing so will increase levels of stress and result in disappointment.  Asset movements on any given day, week, or month are likely to be correlated with your long-term time frame,
• Realize that you will have an emotional response in the face of losses and gains, but rather than react, trust that you have built a portfolio to be resilient in timeframes longer than a day, week, or month.

You build your portfolio for the time frame that is best suited to accomplish your financial and lifestyle goals.  Becoming too focused on the day-to-day movement of your portfolio balance will only undermine the hard work you have already done.

There is More Than Investment Risk When It Comes to Wealth Planning

When it comes to wealth planning, there are other risks to consider besides investment or portfolio risk.  An often overlooked financial and life asset is your career.  One of the best things you can do for your investment portfolio is to focus on your career investment.

Investing in yourself and making sound financial decisions can reduce wealth planning risk.  Wealth management risk becomes more important than asset management risk.  The equation for building wealth is no secret, but it does require a hefty dose of discipline rather than IQ;

• Save as much money as you can in a tax-deferred retirement account,
• Invest in yourself so that you can earn more money,
• Limit the amount of debt that you carry.  

While all of these are critical, probably the most vital and overlooked aspect of investing is investing in one's self.  Investing in yourself and changing your focus can change your financial life.  Maximizing your primary source of income by making yourself valuable to other people in some way is one way to generate increased wealth in addition to saving and making sound financial decisions. 

There's no perfect formula for your willingness, ability, and need to take the risk.  In defining your risk tolerance, your principal objective is balancing your future objectives with your desire to sleep soundly at night.  Again, this applies to not only your portfolio but the other decisions you make in life, which will impact your wealth management plan in total.