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What financial risk looks like to you probably differs from others. Do you define risk as the chance of losing money? Is risk volatility? Is risk something else?
Every financial planning issue revolves around risk. Author Nick Murray says, “The great long-term financial risk isn’t losing your money – it’s outliving your money.”
Dartmouth finance professor Kenneth French defines risk as “uncertainty about lifetime consumption.”
What does risk look like to you?
HOW YOUR LONG-TERM GOALS COLOR RISK
When you make investment decisions you probably are risk averse…you prefer not to experience risk at all. Unfortunately, some element of risk is incorporated within every financial decision that you make. The reason you invest in the first place is because you want to have money available to spend in the future. The decisions you make today are based on your assessment of risk in the present with an eye toward how much money you will need in the future.
Investors usually place too much emphasis on volatility and too little on what the money will be used for in the future. What other sources of money do you have for future expenses? What specifically will you use the money in your portfolio for?
If you allow short-term volatility to scare you away from long-term investing, you are just compounding your long-term financial problems. You may not be entirely comfortable with volatility, but without it, you’ll be very uncomfortable with the impact inflation has on your lifestyle.
Above all else, you should think about risk broadly instead of just specific point-in-time related investment risk. You need to look at how particular investments might contribute to or detract from the uncertainty about your future needs.
WHY CRAVING PRECISION ENHANCES YOUR RISK
If you consider risk holistically you will notice that your craving for precision melts away. You can’t precisely measure how much money you will need in the future; when you will need the money; and how long you will need the money to last.
While you can’t accurately quantify this uncertainty, you can manage it by building a margin of error into your financial planning. Whatever your assumptions might be about the future, they are likely to be proven wrong. Just acknowledging that your view of the future might not be right improves the probability of your long-term success.
The most impactful way to manage risk is to act rationally in the face of uncertainty. After all, your financial behavior matters more than anything else. Sabotaging your long-term goals by reacting to short-term stresses increases your risk and decreases your ability to sustain your lifestyle in the future. Act, don’t react.
Many investors have grown weary of surprises and shocks – that’s perfectly understandable. You can take solace, however, in the parade of economic history that provides a glimpse of how quickly financial markets can heal. Make sure you include that in your visual impression of risk. Start there.