Risk management is a key part of kicking ass with money. Most opportunities have some kind of risk associated with them be it risk failure, lose or other kinds of risk. For instance, accessing water is an essential opportunity in everyone’s life – you need to drink it, you can wash with it, cool down things, etc. It also has risks – it can damage things, make things go mouldy and even kill you. But where would you be if you had no water? So the risks of water as a whole are not completely unavoidable.
Like water, risk is unavoidable in your finances. It runs through things like career choices (how stable/lucrative a job you choose), the size of your emergency fund and even your health choices (health problems can have incredibly negative financial implications).
Bad Things Can Happen When You Avoid Risk Management
In a way, risk is like a mythological monster that grows strong and more powerful with fear. The more it is in the dark, the less you know about it, the more damage it can do. Mistakes can be made when you aren’t aware of the risk of potential choices and alternative choices.
Trying to avoid all risk, rather than take calculated risks
A common fantasy is the idea of a “perfect risk-free” existence overflowing with prosperity and opportunity. Businesses regularly use it to market. They use terms like “try risk-free for 30 days” or “use our service for peace of mind”.
However, this ideal doesn’t exist and strategies that try to remove all risk from life can even be worse than the risk. For instance, living in modern-day society comes with a risk of car accidents – the only way to eliminate that risk completely is to never leave your house – but would it be worth it being a shut-in?
In the financial world, the equivalent response is not investing and keeping all your money in a savings account. You may eliminate the risk of losing money while investing but your money’s value will shrink over time because of inflation guaranteeing a loss.
Setting It and Forgetting It
Risks are always evolving with new ones forming, old ones subsiding and some enduring. An important new set of risks are sustainability risks – how resilient is your financial life to flooding, water shortage and changing climate risks? On the other hand, the risk of being abducted by the Spanish inquisition is pretty low (though no one suspects the Spanish Inquisition). The risks of being seriously ill or dying will always be with us.
Therefore, it’s important to regularly review how your risk profile is changing in your financial life. Are your skills still employable? Do you have a side hustle and emergency fund in case your employer lets you go? Is your will up-to-date with your last wishes and are you still in contact with the executors and trustees?
Taking Unnecessary Risks
Two cents did a great piece on the lottery explaining its ethical and practical problems. In the closing of the video, they point out that most people don’t need lottery size winning to accomplish goals such as quitting a job they hate, starting a business or travelling. There are other less risky and more successful ways to reach these goals. In fact, you’re almost guaranteed to lose money when playing the lottery. It’s a risk that’s unnecessary for most people as that money can be used much more productively with lower risk in other ways.
Fear of Risk Leads You to Act in Ways More Damaging Than The Actual Risk
An example is buying a gun because of the fear of crime. Studies in countries like the US show that this does not actually make you safer. The gun itself is a source of danger that could be used in an accidental shooting, spur-of-the-moment argument or suicide. The response has actually increased the risk in your life.
A fear that often causes financial damage is not a fear of the risk of losing something perse, but the fear of losing out, known as FOMO. Your exhausted, you have had a bad day and know the best thing for you is to curl up with a book and go to bed early. But everyone is going to the bar and it might really be fun – you go out though it really wasn’t worth it in the end and now you are even more exhausted.
Financial FOMO is often expressed as needless consumption, which saps you of money you could use for more worthwhile things. For instance, people get expensive cars and car loans (they can’t afford) to avoid embarrassment because your peers own expensive cars.
Another example is investing FOMO, where investors increase the risks of their investments without properly considering and preparing for the increased risks. Markets are high, everyone is optimistic, so the investor throws away caution and takes on more risk. This leads to the next important point…
Underestimating the Psychological Aspect of Risk
At certain times, it’s very important to keep control and stick to a set plan. You are a tight-rope walker, you don’t want to panic when you are halfway across the rope. When you are a quarterback, you don’t want to force a throw as the defensive line bears down on you. Really, really bad things can happen.
The same is true for investing – when the market has dropped significantly, the media is screaming that’s its the end times and your investments have taken a beating, it’s easy to panic and sell everything. It a classic downward spiral of following the herd – buying high and selling low. Logically, it seems easy to avoid and yet we are not coldly logical machines. It’s important to understand how you will psychologically react to the pressure and anxiety when taking a risk. That’s why financial planners usually talk to their clients to understand their risk profile.
Overblown Fear of Risks Might Manipulate You
Overblown fear of risks is a well-used tool in the manipulator’s toolbox. Manipulators use it in a lot of life be it politics, personal relationships, the workplace and of course, finance. FOMO is a great example – just look how marketers try to show how funner, cooler and sexier life is consuming their products and services.
Another example is myopic politicians and industry leaders that argue “the economy is too delicate to invest in cleaner environment, increase education spending, health spending etc.” They evoke images of chaos and utter collapse of the economy and society. In truth, they are usually discouraging society from making these long-term investments which are critical for a stable and prosperous future. The economy rests on a healthy environment and a healthy, educated population, not the other way around. It’s not the economy or the environment/social investment, it’s the economy and the environment/social investment. I’ll get into this more in-depth next week….
You Fail To Capture Australia at the Start of the Game
You thought I was going to leave out that pun?
Risk Management Doesn’t Need to be Complex
Risk management is often presented as something big organizations and experts do use complex analysis. However, it is accessible and important to individuals as well. Here are a couple of basic questions to guide your risk management:
- Your Goals and Risks – what are your goals and the priority of goals? Which goals are more expendable than others? What are the risks you can least afford? This will identify which risks are more costly than other risks.
- Your choices – what are the different options and how do the risks compare? Alternative options help avoid big risks.
- Your stress threshold – how much stress can you handle before it starts to unacceptably stress and impact your ability to think straight? What kind of situations generate stress and panic in you? For instance, some people can handle the stress of highly volatile investments – others can’t.
Keep It A Yearly Process
It’s good to review your risks on a yearly basis. For example, investors often adjust the allocation of their investment portfolio yearly. Generally speaking, as they get older they lower the risk in the portfolio as they have less time to recover from losses. It’s also useful to gauge your risk profile any time there are any big changes in your life such as a change in your employment situation, responsibilities (say marriage or kids) or a big change in your money situation like an unexpected cost or windfall. For instance, people often decide to get a will when they have kids.
Risk is kind of like a bully – start running and it will always chase you, force you into dead-end situations or sucker punch you out of nowhere. However, if you confront it, keep your eye on it, it’s actually a positive thing in your life because it shows you where the opportunities are.