“Risk taking is inherently failure prone. Otherwise it would be called sure-thing taking.” – Jim McMahon
The Merriam-Webster dictionary defines risk as the possibility of loss or injury; the chance of something going wrong; an outcome that can be different than expected.
People who like the thrill of skydiving or mountain climbing can take great risks in their personal lives, but they would hesitate to take risks with their finances.
However, a survey done for the Investor Education Fund found that almost 25% of individuals who identify themselves as low-risk investors own medium to very high risk products.
Tolerance for risk changes with market conditions
Investors are more optimistic when the markets go up and more pessimistic when the markets go down.
Look at these mutual fund net sales statistics:
- 2007 – $33.49 billion
- 2008 (after market crash) – $107.8 million
- 2013 – $41.9 billion
People who started investing within the last five years or so can be overconfident – believing they can regularly pick winning investments. But maybe they have yet to be tested.
Know Your Client questionnaire
Many of us who work with a financial advisor have completed a questionnaire designed to determine our tolerance for risk.
Here’s a typical question:
If you had $10,000 to invest would you choose an investment that has a potential high of $29,735 in 5 years but could have a potential low of $9,465? The potential loss is minimal here compared to the potential gains.
How about a high of $42,510 vs. a low of $6,250?
Or, a high of $81,316 vs. a low of $4,375?
It’s easy to say you won’t panic in a downturn, but no one really knows how they will react until he or she has experienced a major loss in a bear market. A loss of 20% or more can be disturbing.
Of Canadians who suffered a major loss (at least 20%) in one year, 51% stayed the course. One wonders what happened with the other 49%.
Managing financial risk
“Risk is like fire. If controlled it will help you; if uncontrolled it will rise up and destroy you.” – Theodore Roosevelt
We can’t eliminate or avoid risk, but we can manage it.
Maintain the risk:
- Accept the risk.
- Hope that an out-of-the ordinary event does not happen.
- Deal with the consequences when, and if, they occur.
- Diversify investments.
- Keep savings for emergencies or short-term needs.
- Work with a competent investment advisor.
Transfer the risk:
- Use a third party for protection with the appropriate insurance products.
- Buy a life annuity.
Understand the trade-offs that must be made.
It’s a challenge to determine one’s true risk tolerance. Risk is all about the future, and we know we can’t predict what happens, or control the future. It has a way of turning out in a manner that’s completely different from what we expect.
“Take calculated risks. That’s quite different from being rash.” – General George S. Patton