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The Three Facets of Risk

The Three Facets of Risk

OK, I'll admit it - I'm a risk freak.  

 

It's not that I love to take a ton of risk in my life (though some wonder whether surfing, downhill skiing, hang gliding and scuba diving are appropriate activities for someone in his 50s); it's that I contemplate the concepts of risk. A lot.  

 

That is not a typo. It's the concepts of risk, plural. There are at least three facets of risk that merit consideration: need, ability and willingness.

 

With the Fed's current zero interest rate policy, almost all of us need to take risk to accomplish our retirement objectives. The so-called "risk-free rate of return" is 2.4% per year (fully taxable), which is what the US government gives you for lending it money for 10 years. After taxes, you are probably guaranteed to lose only a little purchasing power over that decade after inflation in factored in. [Yes, that's right: risk-free means almost certain guarantee of losing real value in your investment!] All other things being equal, you'd need to take more risk. 

 

To fully understand your own need, think about what you want your money to do for you, and when you want it done. Want to retire at 65 with $10,000 a month in living expenses? Fine, that requires a certain amount of risk. Retire at 52 with $20,000 a month? No problem - as long as you have $15 million or want to assume a risk profile that makes climbing Mt. Everest look like a walk in the park.  

 

The ability to take risks reflects where you are in life. If you're 28 and starting a job, you have all the ability in the world to take as much risk as you would like. But if you're nearing retirement, or facing health challenges, or are living paycheck to paycheck, you simply do not have an ability to take much risk.

 

Need and ability are fairly quantifiable and objective. The challenge comes in assessing one's willingness to take risks, and this is where most uncertainty lies. Your nest egg, at its most bare, is there to give you peace of mind that you are able to do what you want when you want. But if there's so much risk in the portfolio that you're stressed when the Dow drops a few hundred points... well, that kind of defeats the purpose of peace of mind! [I'm reminded of the investor during the crash of '08 who told me he slept like a baby: woke up crying every few hours curled up in a corner.] 

 

Ask someone their long term risk tolerance when the market has been down six months in a row and you'll get a markedly different answer than you would when the market is roaring ahead (recency bias). Or notice reticence to change? That's status quo bias. Oh, there are plenty more, but here's the takeaway: understanding risk requires time and patience, and a recognition that it's a dynamic concept.   

 

The riskiest approach? Not knowing how much risk you need to take, you're able to take and that you're willing to take!

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