Reinvigorate Your Financial Life With Laser Focus on Market Risk and Shortfall Risk

The financial world is noisy and it’s easy to become distracted from your most important long-term goals.

One way to cut through the noise is to focus on just the two factors that ultimately determine your approach to everything else in your financial life; namely, Market Risk and Shortfall Risk. Market Risk is the inherent risk of investing in the market; Shortfall Risk is the risk of failing to accomplish your goals.

We routinely see clients who suffer the effects of “market stress”. In many respects, this is self-imposed worry resulting from a misunderstanding of how capital markets function. Since financial literacy is largely untaught, this lack of understanding is not surprising. Part of our role, of course, is to help clients remain goals focused instead of market focused.

However, since we are all emotional beings, we sometimes see clients react emotionally to market changes. This can set us up the proverbial “horns of a dilemma”, between these two very distinctive types of risk. Without a willingness to accept some level of Market Risk the larger and potentially more problematic Shortfall Risk come into play.

Stay on Course

The dilemma presents itself very clearly. If you cannot accept the normal price changes in the markets, then you likely will find yourself decreasing one type of risk (market risk) and exchanging this for the other type of risk (shortfall risk).

The average intra-year price decline in the S&P 500 is over 14% for the calendar years dating back to 1980. In about 75% of those years, the S&P 500 had a positive year overall. You have to be able to stay on plan (in the market), in order to reap the benefits (the returns). The stress comes from believing that this tradeoff can be avoided; it can’t.

There absolutely are individuals who for various reasons can’t fully reconcile this dilemma. This point should not be downplayed...if you can’t accept the risk, don’t invest in the stock market. You will likely need to adjust your lifestyle and future plans, but that is a financial planning choice.