No cute or clever wordplay on this one. I want to talk about risks in investing.
This is salient because risk is often misunderstood and because the markets are displaying increased volatility – where market swings can be 3-4% up or down in a day. I want to arm you with a framework to analyze risks. This is the only way to make good decisions.
There is a general misunderstanding of risk in relation to investing. A lot of people think risk is a “thing” with defined boundaries and a solid, immovable shape. But quite the opposite.
Risk in terms of personal finance can actually be categorized into 3 separate entities that interact with each other. They are like a set of siblings.
So what are these 3 siblings of Risk?
- Investment risk – this is the risk that is associated with the investment itself. So if you are invested in equities there are certain risks associated with stocks. There are different ones associated with bonds or even cash. There is a litany of things that go in here: market risk, interest rate risk, currency risk. All these things have nothing to do with the investor, but everything to do with how an investment product is constructed and how it performs. This exists independent of any investor. I think of them as the older sibling – independent.
- Ability to take risks – this has to do with your general circumstances. Your age, your financial situation, if you have kids or a mortgage, your salary or earning potential. I call Ability, the middle child. The middle child is often forgotten or overlooked, but have considerable contributions and can tip arguments one way or the other. Most people will concentrate on investment risk alone or only listen to the next sibling.
- Willingness to take risks: this is how you feel about risk. And this is where most people get tripped up. This risk is completely subjective. So I call Willingness the youngest child. This is usually the sibling that gets their way, either by throwing a tantrum or by playing it sweet & coy. The youngest sibling has a reputation for getting all the attention and their way in families. In investing, it’s the same. This is also where the old adage that fear and greed are the only 2 emotions in investing comes true.
Knowing is Half the Battle
So we know there are 3 elements to risk in personal finance. Now we dive a bit deeper to learn more about each.
This information is widely available, especially in the age of the internet. Investopedia, Google can provide you with basic definitions and examples of investment risks. The thing to remember about these risks is that they apply to everyone. They are “general”
For example, usually, Cash (or Money Market funds, High-interest rate savings accounts, treasury bills) is generally thought to be “risk-free”. This is a generalization. The truth of the statement depends on the government of the country you are in. So in Canada and USA, how stable is the government for you to know that the dollars you have in your wallet are as good tomorrow as they are today? And the stability affects everyone in that country.
The same thing with Stocks – over this past week, stocks were down in general. If everyone was holding the same basket of stocks, everyone’s losses were the same, say 5%. The price of a particular stock falls the same amount for everyone who owns it.
Ability to take risks:
Here we get into personal circumstances. In general, the more money you already have, the more able you are to take risks. The younger you are, the more able you are to take risks. Those are just rules of thumb. There are many more elements that go into ability.
For age, if time is on your side, you can take more risks. If it doesn’t work out, you can start over easily. This is why people tell you to travel when you are young, to take career risks when you are young. You can date a bunch of assholes when you are young but as you get older, you don’t want to be wasting your time anymore. Same with investing. If you lose your invested money, you still have time to make more and start over.
Ability also has to do with how much money you already have. You can’t compare yourself to say, Warren Buffet, in terms of taking risks. Unless you are Bill Gates, you simply do not have as much money as he does. Of course, Buffet has much to teach us about investing, I’m not saying that he doesn’t, but you can’t just blindly mimic his strategy and call it a day.
Ability is not saying you have to avoid strategies or investments. It’s about objectively looking at what about your circumstance is a strength and what is a detractor and making a decision that considers them. If you are in a dual income household, or if you have a safety net. Or maybe you have young children or a disability in your family. These will change your circumstance versus another person.
Often, ability is behind the scenes. You see your friend take on really risky investments, but what you don’t see is that they just got an inheritance from a great aunt. Or you see a young person not taking enough risks, but it’s really because they are supporting their younger sibling and putting them through school.
Willingness to Take Risks
This has everything to do with emotions. People often say that emotions have no part in investing. Bull crap, I say! Because we are humans doing the investing, that’s why.
You don’t have to be a slave to your feelings, but I do recommend you get to know your emotions when it comes to investing. Suppressing emotions is like trying to plug up a geyser with rocks. Sooner or later, it’ll blow! So get to know your emotions and understand which emotion is driving your decision.
The secret is to RESPOND and not REACT. The only way you can choose to respond is if you have a bit of S-P-A-C-E between an emotion and a behavior.
When the market is going haywire and falling, when headlines are all about “crashes” and “bloodbaths”, think of that as a family member pushing your buttons.
Now you can react and panic and rush to sell your investments, like turning around and bite the head off your family member. Or you can respond by taking a deep breath, acknowledging that feeling (anger, panic, worry) and then engage in the rational part of our brains. We remind ourselves that our time horizon is long and that ups and downs are part of a normal market.
Putting It All Together
Ok, so how can you use this information?
First I’d start with ability – to objectively look at how much risk are you really able to take. I’ll give you my example to illustrate. I make 6 figures in a high cost of living city. But I own my place and have a small mortgage. My job is rather secure and I don’t have to support anyone but me. I keep my expenses low and have no debt. I have an emergency fund and I’ve also built up my investment portfolio over the past 10 years. My company also provides me with a defined benefit pension. I belong to the Gen X demographic, so while I’m no spring chicken, I still have time on my side.
As a result, my ability to take risks is pretty high.
Next, I consider willingness to take risks. Again, I use my own example to illustrate. I know myself and my temperament pretty well. This week, while markets were down, headlines were screaming and my portfolio showed all red, I kinda went “meh” and shrugged my shoulders. Plus, because I’ve been in the investment industry for years and have 2 designations related to investing, my willingness is very high.
For some others, this is not the case. I know family members that get upset if they see any sort of loss in their accounts. They will fret and worry about it. It causes them a lot of stress. So their willingness is lower than mine.
Finally, knowing where we stand in terms of the previous two risk elements, we can find the best investments for us.
Considering the interaction of high ability and high willingness to take risks, my portfolio is composed of higher amounts of higher-risk investments. I own mostly stocks and some are riskier than others. If the interaction was of low ability and low willingness, my type of portfolio wouldn’t work.
What Should You Do Now?
Now you have this example, take a sheet of paper and divide it into thirds. On the left side, write the header: Ability. In the middle, write the header: Willingness. On the right, write the header: Investment risk.
Next go through the exercise of writing down what your ability, willingness and investment risks are.
Log on to your accounts see how your investments actually line up with your analysis.
If they are in alignment – awesome. You are on the right track! Keep going!
If they are NOT aligned – awesome. You know you need to make some changes and what to do next.
Now go make those changes! That could be saving more to increase your ability. Or you can read up on and learn more about investments to increase your willingness. Maybe it is adjusting your investments to suit your circumstances better.
By knowing these elements of risk, you can set yourself up to weather the ups and downs of investing.
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Originally published at sundaybrunchcafe.com