Perhaps one of the most confused word we use in finance – and perhaps in life in general – is risk.
I recently was reviewing the annual update of my firm’s ADV, and was reminded of the different types of risk that investments are subject to: market risk, strategy risk, small company risk, turnover risk, limited market risk, concentration risk, interest rate risk.
We have risks in life that we commonly insure against. Our homes burning down. Our vehicles being totaled. Our physical ability to earn income. Us or loved ones dying earlier than expected. Healthcare and medical expenses.
We have risks that we don’t think about as frequently. Inflation risk. Longevity risk. Income stability risk. Legal liability risk.
And these are just the financial types of risk in our lives.
Think about other areas or risk. Families splitting. Depression and mental illness. Job opportunities. Losing a physical sense like vision. Creative ideas flopping. Getting rejected on a date. Losing a game.
This post doesn’t have an alarmist agenda, I’m simply pointing out that the very essence of living involves risk of different components.
(And to perhaps quickly address the financial aspects of risk management – you should generally insure against low probability, very expensive risks and you should generally not insure against high probability, not expensive other risks.)
But what is risk? Oftentimes people define it as the loss of something – which is true, but perhaps doesn’t capture all dimensions of it.
I think risk is simply the chance that something doesn’t go according to plan.
And if we accept that, then we need to accept the fact that our plans – financial and non – need to be flexible and need to be able to adapt.
In addition, the more complex the situation, the more different, independent risks and variables are involved.
As a somewhat benign example – I recently lost in the championship game in a fantasy football league. Heading into playoffs, I was vying for a 2nd seed and a first round bye. Waiting for the final Monday night game of the week, I had three things that needed to happen for me to secure the bye. One had a 90% chance (my team needed to win), one had a 70% chance (a certain team needed to lose), and one had a 69% chance (another team needed to lose). Taken individually, they were all probable events – arguably even “low” risk. However, taken as a whole for all three to happen, I only stood a 43% chance. And, as the odds held up, I missed the bye (but still knocked out the #1 seed in the second round – only to lose to the #2 seed who – coincidentally – did claim that bye).
You can take a similar principle and apply it to life and to finances.
Complex financial plans that may include retirement projections have so many different, independent variables of risk, which taken as a whole are mind-spinning to fully grasp. Only one aspect needs to go dreadfully wrong to wreck a plan.
We can do all of the right things that we can trying to raise healthy, grounded, mature kids, and still have the risk something goes terribly wrong.
We can create business plans that account for all types of risk we can think up on a SWOT analysis and benchmarking studies, and still be blindsided by something we didn’t account for.
We can put our heart and soul into a creative endeavor for the world to experience only to receive boos – or maybe even worse – silence (as Nick Maggiulli elegantly wrote).
However, this doesn’t mean we don’t do these things.
We just acknowledge that risk is the price of admission to anything worthwhile.
The new company doesn’t get started without the founder risking failure.
The artwork doesn’t get noticed without the artist risking rejection.
The football team doesn’t win the state championship without the team risking loss.
The marriage doesn’t come to existence without the partners risking heartbreak.
The investment portfolio doesn’t substantially grow without the investor risking principal.
The new client doesn’t get acquired without the salesperson risking a denial.
The child never learns to ride a bike without risking a scraped knee.
There are some types of risk that you can insure against. There are other types that you can diversify against. And there are other types you simply can’t do anything about.
It’s virtually impossible to eliminate all risk. And that’s ok. As long as we’re aware of it, and we recognize the importance of flexibility.
So again – risk is three things.
Risk is (1) a part of life that (2) accounts for things not going according to plan, but (3) is the price of admission for achieving anything worthwhile.
And once we realize it, maybe risk isn’t as scary – nor as difficult to define – as we think.
Photo by Loic Leray on Unsplash