In my last post, Understanding Risk, the four tactics on to how to deal with risk, include: reduction, retention, avoidance, and transfer. To follow the correct path, one needs to pay attention to the likelihood of a result and the associated cost. Today, we examine risk characteristics to gain a deeper understanding of how it applies to our lives.
Risk Capacity is your ability to withstand the impact of a negative outcome. For example, a teenager typically recovers more quickly from a skateboard accident, while a senior citizen may experience a slower healing.
Financially, you need to review the importance of negative hurtles facing your goals. If you are closer to retirement, pay attention to sequence risk. It is the impact of having large negative portfolio returns in the first years of distribution.
Children often hear, “Beauty is in the eye of the beholder.” The same is true for risk perception, where one individual may see excessive risk, another sees opportunity. One important difference does exist from beauty; risk is not subjective. Planners measure risk in many different ways: portfolio beta, standard deviation, and upside to downside ratios.
When perceived risk does not reflect the real risk, a behavior may change. For example, would the employees’ perception of the bankrupt companies, Enron, General Motors, Delphi, and Lehman Brothers lead to different behavior if they would have fully understood the risk before such a negative experience?
To achieve a stated objective, some risk is required. From a financial plan view, resources, savings rate, goals, life expectancy, inflation, and taxes are just a few elements needed to discover required risk.
Usually, it is a minimum result needed to achieve the desired result.
Risk tolerance is a measurement of how people respond emotionally to taking a risk. Psychologically no two people have the same emotional makeup so no universal standard applies.
In the investing arena, we often fill out a survey to “discover” our risk tolerance with questions like: How do you feel about a market decline of 20%? What would you do in situation X? Two problems exist with this approach: 1. Most investors do not realize when an X event has taken place to assess, how they felt or know what action they took. Also, research shows we are inaccurate at being able to recall events. 2. As previously noted universal surveys are difficult to apply in these situations. In reality, each person has his own history with risk.
After understanding the tactics and characteristics of risk, you now have better tools to assess opportunities and deal with a changing landscape. Practice applying the principles by asking questions when you have meetings with your financial, and health professionals.