February 23, 2022 – The financial services industry speaks a lot about the concept of RISK. We have all heard that investing money carries associated risk, and it’s possible to lose all of your money. Professionals explain that future returns are not guaranteed, and that past performance does not indicate future performance. They provide descriptions of the many risks you will face: market risk, credit risk, interest rate risk, liquidity risk, currency risk, etc. It reminds me of the pharmaceutical industry, which also has a legal obligation to advertise the possible side effects of their drugs. Wouldn’t you wonder why anyone would take those potentially devastating risks?
I believe any legislation put into place to alert consumers of risk is well intentioned. We must protect our citizenry from the con artists, scammers, cheaters, and generally unethical people trying to take advantage of others or the situations they are facing. However, I struggle to determine if these laws, meant to protect us, are indeed effective for the consumers of financial services? Fundamentally, there are three questions we must ask and answer to be covered:
- Do you understand the risks you are facing?
- Do you understand how to make an informed decision about taking a risk?
- Do you understand what to do should the risk become too great?
UNDERSTANDING RISK
When I ask clients to define risk, they will respond that “it is the chance of losing something,” and usually when speaking to me, they are referring to their money! The “probability of loss” is the textbook definition of risk. Since the only constant in life is change, and change brings uncertainty, a person who does not adapt well to change is usually averse to risk. Consequently, many people invest a great deal of effort into reducing uncertainty. There are two problems with this approach. The first is that we often don’t understand uncertainty very well. The second is that profitable opportunities only exist where outcomes are genuinely uncertain.
Frank Knight wrote about this in 1921, in a great book called Risk, Uncertainty and Profit. He distinguished between two types of uncertainty. The first type is when we know the potential outcomes in advance, and we may even know the odds of these outcomes in advance. Anyone who participates in “games of chance” understands the concept of risk. The simplest example is rolling a pair of dice. Before we take a roll, we know in advance the odds for each possible outcome, provided that the dice are fair. Knowing these odds forms the basis for all of the games of chance that we can play. Dice are relatively simple, cards a bit more complicated, but we can know all of the odds with them in advance. Knight calls this type of uncertainty risk.
We sometimes experience uncertainty, but we don’t know the possible outcomes in advance, let alone their probabilities. We consider this circumstance to be “genuine uncertainty,” and it occurs in complex systems, where there are a lot of actors and factors interacting at the same time.
Let me try to explain how this might apply to your investment portfolio. In the spirit of Capitalism, each of us can make money in three primary ways: investing our Human Capital, which provides a return from “the sweat of the brow”; Social Capital, which provides returns from relationships like marriage, divorce, inheritance, or a legal settlement; and Financial Capital, which is investing your money to obtain more money in return. We will place our “risk focus” today on Financial Capital. But rest assured, there are many other risks to consider. There is much to say about the dangers endemic to the investment of your Human and Social Capital, but that conversation is for another day!
Capital Markets is part of our financial system. Companies raise capital to run their business, either by selling you a share of their profits or borrowing money, which entitles you to interest payments — the Equity Markets and Bond Markets, respectively. The value of your investments is based both on the past performance of these companies and the perception of the market participants on how well the company will do in the future. Past performance is presumed to be factual and accurate, and that’s a good indicator, but future performance introduces us to the first level of uncertainty. How will the United States and other countries around the world perform, and will they be supportive or detrimental to the businesses we have invested in?
Economic systems have been in place since the Greek and Roman days, and economics as a separate discipline can be traced back to 1776, when Adam Smith published the “Wealth of Nations.” Suffice it to say, there have been a satisfactory number of economic cycles, with myriad indicators, that can be studied to predict the probability of financial performance over the near term. Such is the essence of an Economist. Given the importance of these indications to the Capital Markets’ direction, this talent is sought after by banks, financial service firms, the financial press, and publishers.
Allow me to introduce one additional concept, volatility. Volatility is an investment term that describes the rate at which the price of a stock increases or decreases over a particular period. When a market or security experiences periods of unpredictable, and sometimes sharp, price movements, it is said the market is experiencing high volatility. People often think about volatility only when prices fall. However, volatility can also refer to sudden price increases.
Suppose we are experiencing a somewhat stable economy, with economic indicators behaving within the expected range, given the current stage of the economic cycle. In that case, the market valuations will operate in a similar typical range yielding a period of low volatility. However, today’s economy is dealing with a late-stage pandemic, labor shortages, supply chain issues, the elimination of Government liquidity to the market, higher interest rates, and international tensions. Considering all of this, you can understand why stock market volatility is rising. The multiple factors affecting the economy provide the recipe for “real uncertainty” where outcomes are unknown, and probabilities cannot be determined. Real uncertainty is more difficult to manage than uncertainty risk.
However, Knight’s critical point is this: meaningful opportunities for profit only exist in the face of genuine uncertainty. This means that if your plan requires “outsized” returns on Financial Capital, you not only have to deal with uncertainty, you must seek it out and be prepared to take action.
To recap, risk refers to decision-making situations under which all potential outcomes and their likelihood of occurrences are known to the decision-maker. In contrast, uncertainty reflects conditions where outcomes and their probabilities of occurrence are unknown to the decision-maker.
Life is a series of calculated risks – nothing more. Everything that you decide to do has a margin of risk. No outcome is ever 100 percent certain, and, therefore, any attempt at anything has a chance of complete failure. We risk everything every day of our lives without knowing it.
ARE YOU A RISK-TAKER?
I am with my family, lying on the beach and watching the storm clouds roll in from a distance. The ocean water is turbulent, waves have strong riptides, and there is no lifeguard on duty. I understand the risks, and it is an easy decision – no way I am going for a swim. I then notice that my eight-year-old granddaughter has ventured into the water. She knows how to swim, but struggles to stay afloat. Without hesitation, I navigate the choppy seas and bring her back to shore. Same risks, but with a different and even easier decision to make. Why? It’s because the decision to take a risk must be weighed against the potential outcome of taking (or not taking) the risk.
As Financial Life Guides, we constantly discuss the concept of risk with our clients. When managing their invested Financial Capital, we explain the risks of a proposed portfolio within the context of historical results, both positive (returns) and negative (drawdowns). We can then simulate how the range of potential outcomes might affect their goals, dreams, and desires – their financial plan. The results help to put risk in real terms.
We also have an honest conversation with clients about their tolerance to take a risk. I maintain that risk tolerance is a personality trait, a relatively consistent internal characteristic resulting from a person’s typical thinking, feeling, and acting. It is one of their cognitive behaviors. Often, I will ask clients to reflect on how they feel today, how they felt in 2008, and how they felt in March of 2020. I will inquire about their level of concern, during each of those periods of extreme market volatility, as it relates their portfolio, and if that concern had any impact on their sleeping habits. I refer to this exercise as my pillow theory. The good news is that, unlike a person’s values, personality traits can change over time, either through different experiences or a more proactive effort to modify behavior.
Clients need to assess their capacity to take risks by considering the risks present in other aspects of their life. Remember, your Human Capital and Social Capital are working side by side with your Financial Capital. Consider your employment situation. Is your job stable, and are you in good standing? Is your compensation predictable and reflective of the value you put forth? What about your Social Capital? Are your relationships stable? Do your children have special needs that might need added attention? Do you have a support structure to assist you, should the going get tough? These factors are easy to identify (if you are truthful with yourself) and have a significant impact on the construction of your investment portfolio.
Simply put, a person’s risk capacity could then translate into whether someone’s life is like a bond (stable, consistent, simple) or more like a stock (variable, volatile and complex). By way of example, a tenured professor at a prestigious university who is still married to their childhood sweetheart is viewed as a high-quality bond portfolio. On the other hand, a self-employed business owner trying to make their third business venture a success would more likely be considered to have stock-like qualities. These designations help clients understand the need to diversify the risks in their life.
Probably the factor least considered by clients and the financial services industry as a whole is a person’s “need” to take a risk. If one of the possible outcomes of taking added risk is greater returns, is there a point where you have “enough” money that the risk is not worth taking? What if you are at the point where the risk of loss is significantly more painful than the potential for gain? With our clients, we ask them to consider “how much is enough?” We call this exercise “setting the goalposts.” Without the end game in mind, you will never know how far you have to go, and continuing to take “unneeded risk” exposes yourself to the worst outcome, the risk of losing what you have already gained! I would consider this situation more painful than trying and failing because losing what you already had is not only preventable, but it is also a measure of greed or stupidity, or both. This catastrophe happens more often than you think, even to intelligent people who understand finance and work with financial advisors.
There are at least three reasons this situation occurs:
- The focus is placed on the reward and not the risk. The opposite behavior that focuses purely on risk without considering the potential rewards is equally preventable but not quite as painful!
- It is hard to visualize “enough money” because some people believe “it is never enough.” Their wealth goal always seeks $1 more! Sophisticated financial planning software can help contextualize the probability of meeting a set of defined plans, but is helpless unless an endpoint is considered.
- The financial services industry prides itself on delivering complex solutions which are explained using complex jargon. Complexity is a risk factor that adds to the possibility of losses incurred when chasing unneeded returns. Additionally, complexity commands a higher fee structure, while simplicity does not.
Earlier in this essay, we explained the difference between “risk” and “genuine uncertainty.” This distinction is critical to understand because your ability to attain a meaningful amount of profit in a relatively short period is significantly enhanced in periods of genuine uncertainty. Hitting it big with lottery tickets is a “sucker bet” because the odds of winning are higher than the payout you can expect. However, in times of genuine uncertainty, the odds of winning are usually lower than the payout. Taking advantage of this situation is a clever play.
What to Do Should the Risk Become “Not Worth It”?
Once you understand the risks that may lie ahead and have considered the factors leading to an informed risk-taking decision, you may ask yourself what happens if you make the wrong choice?
The simple answer is you change and adapt to the new situation. But you ask, what if the outcome is unrecoverable? What if I am ready to change but don’t know what to do?
It is true that the first premise, an unfortunate outcome, is always a possibility. However, the chance of not recovering from the result, or not having any option to move forward, is meager because the risk-taking decision process will not allow this situation to occur. You have understood the risk and have considered the merits of taking the risk, and you are willing to take the odds. You also have analyzed the range of expected outcomes and have a plan which provides the new course of action you would need to adopt to stay on track.
Simply put, you will not take financial risks that have catastrophic outcomes. And for the risks you do take, you are prepared to take the action that will allow you to progress.
In his book “The Psychology of Money,” Morgan Housel states that there are many things never worth risking, no matter the potential gain. Each of these is considered invaluable:
- Your Reputation
- Your Freedom and Independence
- Your Family and Friends
- Your Happiness
- Being Loved by Those Who You Want to Love You
Your best shot at keeping these things is knowing when it’s time to stop taking risks that might harm them — knowing when you have enough!