Risk is the chance of loss, and for most of history it was viewed as that. There is a chance I’m going to lose. But in the capitalist system, risk is also an opportunity. Nothing ventured, nothing gained is as important to keep in mind as the fear that if I don’t manage my affairs, I can get wiped out.-Peter Bernstein
The longer we are in this business, the more we realize we are in the business of being risk managers. For each of our clients, we need to manage what is an appropriate amount of risk to take in order to achieve their goals and when and where is an opportune time to take a risk.
While investment folks tend to overemphasize the opportunity and neglect the risk calculation, we look to insurance folks to understand risk better. As a simple example, let’s think about the risk of your house burning.
The first thing you can do is mitigate the risk. Clearing brush and rubble from around your house, owning a fire extinguisher, etc. reduces the chance of your house burning. In investing, diversification is our first line of defense to mitigate risk. By not putting all our eggs in one basket, we significantly reduce the chance of large losses.
The second thing you can do is transfer risk. You pay to an insurance company fixed premiums and in return they are liable for the cost of a fire loss to your home. The transfer of this risk makes great sense because it is highly unlikely that you will have a fire but, if you do, the loss is severe and potentially devastating. In investing, there are some limited ways to “pay premiums” and shift risks. These would include buying and selling options on your investments, purchasing market linked CDs, and purchasing insurance products with guarantees. Part of our job is to make sure that the premiums are worth paying for the benefits you receive in risk reduction.
Lastly, you can accept risk. Your house contains a nice art collection well in excess of what is covered on your house policy. Rather than pay a high premium to cover the collection against fire damage, you might decide that a fire is highly unlikely and that you are willing to take the risk in order to own and enjoy your artwork. In the case of investments, we are essentially deciding the opportunity provided by each investment is worth accepting the risk of loss that it entails. This is a moving target and our assessment is an ongoing process. Owning a tech stock today is far less risky than owning one was in 2000 due to the highly inflated value of tech stocks in 2000. The same investment today may have a small portion of the risk it had back then.
Risk is a dynamic threat and opportunity. We must budget risk and re-value it constantly in order to have a successful life voyage.
By Ted Schwartz, CFP©