Understanding Risk
I used to watch Deadliest Catch nonstop on the Discovery Channel. The show follows different crews fishing for Alaskan King Crab in the Bering Sea. Working on these boats is one of the most dangerous jobs in the world. Chunks of ice and crab pots crashed around the deck while the boats maneuvered the dangerous sea waters. On the bright side, the crewman could earn around $50,000 working on the boats for three months. Not too bad! So that makes me wonder, is $50,000 worth the risk of putting myself in that environment for three months?
I want to help you understand risk tolerance and the different types of risk you will encounter when investing. Risk is an important topic even if your only investment is through a workplace retirement plan, such as a 401(k). It is vital to determine your risk tolerance an use that information to make investment decisions. I will also cover the important types of risks that you need to consider. It isn’t as simple as saying “Stocks are riskier than bonds.”
As you can imagine, people have different responses to the crab fishing question. We all have different levels of acceptable risk based on our age, gender, financial situation, and goals. Do you think a 25-year-old and 75-year-old would accept the same pay to be on a crab boat for three straight months? What about two 25-year-olds who are both in great shape, but one is significantly in debt and the other is a millionaire? That’s why the first step in this process is to determine your risk tolerance. The best way to do this is through a questionnaire that will analyze your answers and provide an explanation of your comfort level with risk.
Unfortunately, most people stop there. They take questionnaires that ask ridiculous questions such as, “If you had the opportunity to invest in a stock that could quadruple your money in a year or lose it all, how much would you invest? Nothing, 3 months’ salary, 6 months’ salary, or a full years’ salary.” These answers are unreasonable. That question doesn’t analyze risk as much as it analyzes whether you are a sucker for sales pitches. The biggest issue I see is that people take questionnaires that tell them they are average risk takers or conservative investors and then want to keep their money in a savings account or out of the stock market. In almost every case, that won’t allow you to save enough for retirement. You need to understand your risk tolerance first, but then apply it to your situation, goals, and the various forms of risk in investing.
Here are a few significant types of risk and how to consider them during your investment decisions.
Market Risk – This is what most people discuss when they refer to risk in investing. People assume stocks are riskier than bonds because bonds pay a fixed interest and stock prices fluctuate more than bond prices. However, it isn’t that simple. Don’t confuse price volatility with risk. Just because the price of a stock goes up and down faster than bond prices does not mean that your money is more at risk. Another aspect of market risk is that small companies are riskier than large companies. This makes sense to all of us. Smaller companies have less historical information, so investors require a higher return for the additional risk that they are taking on. Your risk tolerance score should be taken into consideration when determining how much market risk you want to accept, but your score should be a smaller factor than your long-term investing goals.
Concentration Risk – Diversification. Everyone has been lectured on this topic. Investing in one stock, in one sector of the market, or in one type of asset is always riskier than spreading out your investments. Diversification limits your potential gains if you pick the right investment, but more importantly, it protects you from losing too much if you choose wrong. When your investments are concentrated in one stock, you should expect that stock to outperform the market significantly for you to take the risk that it could fail. This area is where your risk tolerance score can help you decide how well you could handle investing in individual stocks.
One point of emphasis on concentration risk. Check your 401(k) holdings to see how much of your account is in your company stock. Your company could fail no matter how great you think it is. Just look back at the Enron employees who had their accounts invested entirely in Enron stock.
Longevity Risk – What are the chances that you will outlive your money? As I mentioned earlier, this is where the risk tolerance score significantly fails people. When your risk tolerance is low, it will suggest that you invest more in bonds and cash. However, that may not allow you to have enough money throughout retirement. I would love to advise people to put all their money into a savings account if that would allow them to save enough for retirement. Unfortunately, savings accounts generally don’t keep up with inflation which means that your money can buy less and less over the years.
Behavioral Risk & Horizon Risk – These are two separate types of risk, but I included them together because they both describe the same scenario. What is the likelihood that you will sell your investments at a bad time? You may have an emergency and need to take the money out of your account. Worse yet, you may get worried about the market dropping and sell your investments at the worst time. These risks are impossible to determine from a risk tolerance score because nobody can accurately predict how they will behave in a down market. In my opinion, managing this risk is the most important job of a financial advisor.
You may see articles describing other types of investment risk, but these are the concepts that the average investor should understand. Your investments should match your risk tolerance, but also align with your overall goals. Your risk tolerance will also change over time as your life changes. It’s an ongoing analysis. Be aware that answering questions about your opinion on how risky you are is significantly different than real life situations. How would you react when living through a period where your investment account drops every month? What happens when your “sure thing” stock starts dropping? Will you be relaxed or start worrying every day about that one investment? Anyone who watches Deadliest Catch could convince themselves that they could spend three months suffering for $50,000. But what about when they are standing in the Alaskan harbor? Would they actually get on the boat when it was time to go? Maybe. Or they might turn to the captain and say, “How about $100,000?”
Mike Zeiter, CPA/PFS
