HOW TO MEASURE RISK
As I fly to my mother in laws funeral, I’m overcome with the riskiness of life. It’s not that Ruth went before her time, on the contrary she died at age 90 after a full life. She raised 2 successful sons, was married to the love of her life for 67 years, and died in the same home in which she, her brother, and her children all grew up.
risk
Yet, even though we knew Ruth would pass, it came as a shock when the phone rang at 4:30 AM the other morning. I was overcome with feelilng and reminded of the uncertainty of life.
Now, I’m a planner and come from a planner. My mom has already prepaid my dad and her funeral expenses. She has all the details laid out. She inquires months in advance when I can visit and when can she come to stay with us. She and my dad had appropriate insurance for all eventualities which came in handy when they were sued one time.
Yet with all the insurance and planning in the world, one cannot avoid risk. Actually, if we thought about all the risks we encounter every day, we would probably stay in bed and never leave. Of course the recent devastation of Hurricane Sandy is yet another reminder of our lack of control.
Throughout the Investments Class I teach to MBA students, the underlying theme is balancing risk management with wealth building through investing. Yet, look back on the mortgage debt crisis of 2007-2008, or the dot com bubble bursting the beginning of this century any investor knows risky drops in the stock market are inevitable.
So how does one measure and protect against risk?
Risks in Investing and Wealth Building:
Which of these risks keep you up at night?
- That your investment portfolio will decline in value
- That your investments won’t increase your wealth as much as expected or planned
- That your wealth building strategies fail
- That you’ll lose your job
- That your entrepreneurial venture will fail
- That you fail to save enough for retirement
- That you’ll never pay off your credit card debt and start building wealth
How to Measure Risk
The best and yet albeit imperfect method of measuring risk is to look to history. What was the greatest stock market decline in one year? How likely is it that someone in my industry and position will lose their job? How much money will I realistically need to live in retirement? And will the historical 3% inflation rate continue in the future?
History may or may not repeat itself, but the last time I checked, it’s fairly difficult to predict the future. So if you want to measure risk and prepare as much as possible, use history as a guide and then be a bit more conservative and look at some worse case scenarios.
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Investing Risk
Stocks, bonds, and cash are all risky investments. Historically, stocks gained an average of 7+% over the last 100 years or so. Bonds gained about 5% and cash about 3%. All looks great, but…… underneath those rosy averages are decades (like the first one of this century) where stocks barely increased at all. And right now cash is not paying a return. Factor in inflation and you’re losing money on your cash.
To guard against the risk of investing, there are two solutions; Asset Allocation and automatic saving.
Asset Allocation means so when one investment goes down, the others will cushion the blow and your entire portfolio will be less volatile.
Automatic saving into your desired asset allocation means that when investing in stock investments, you’ll buy more shares when prices are low and less when they’re high. The sooner you begin, the sooner your portfolio will benefit from the compounding of your returns. Simply put, compounding means that your money is building on the money you already have.
These two investment strategies won’t guarantee that you won’t have a losing year once in awhile, but will help cushion the ups and downs. It will also help you grow your wealth long term.
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Career Risk
Education is like the asset allocation of employment. The more you grow your skill base, the greater your importance to your company and employer. There’s also data from the bureau of labor statistics which shows that more education is correlated with higher income and less unemployment.
Creating additional income streams cushions against the possibility of unemployment. If one income stream dries up, you have other’s to rely on. Shwanda, a close friend has a salaried job with a university, book royalty and consulting income. Although her main income is from her university job, if that income dries up, she still has other monies coming in.
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Retirement Risk
Retirement risk is very real as many 40-50 year olds are staring retirement down with little savings, too much debt, and worries about social security. Start saving and investing now. Even if you have little saved now, it is not too late. Get rid of your debt. And confront yourself and your lifestyle decisions. Look into alternate income streams for retirement. Examine your lifestyle decisions and determine whether they are sustainable or not. Confront your future, avoiding will only make it worse. And if you can’t do it on your own, see a money counselor, life coach, or therapist to help you along.
Without money for the future, you will be dependent upon the government and loved ones for your support. Is that how you want to spend your later years?
How do you prepare for the risks in your life?
image credit; google images-CNN Money
Excellent post and please accept my condolences on your loss.
Too many investors focus only on the upside potential of their holdings. Sadly these investors often learn about the importance of risk control by painful experience.
Very helpful enumeration of risks in order to arrive with realistic and more precise estimations. I guess it’s a matter of balancing advantage vs. risks. Some established trends and less risk but sure-win arrangements are good priorities.
I think we all assess risk differently. For example, I accept volatility in my investments because I am willing to take on more risk. Most (maybe all)of my basic expenses of retirement are covered by Social Security and a pension. In other words, my necessities are covered and my wants are satisfied by my investments.
Awesome post! I am also sorry to hear of your loss. I am a planner as well, so I do my homework and try to prepare ourselves appropriately. No one is immune to risk, but it can be possible to lower its impact.
@Roger, Amy, Krantc, and John, Thank you for your condolences. I appreciate all of the remarks about risk. It’s so important to be aware of the risks one can control. And when possible understand your potential losses. In fact, experiencing a personal loss, puts the fragility of life into perspective.
Sorry about your loss.
As for risks, there sure are a variety of them, and the reality is that they are a part of life. This include our finances, whether it’s income, investment, or other risks.
The one that you put in there, which I hope doesn’t get lost, is the 3% inflation rate risk. People aren’t thinking too much about this as of late, and admittedly that includes me. But there have been times with much higher rates of inflation, and a repeat of that can wreak havoc with many a retirement plan and lifestyle. Important to not forget about this risk!
@DPF-I totally agree with your remarks that with recent low inflation rates folks tend to forget that the recent past is not indicative of the normal inflation rates. The average historical inflation rates are 3% with highs in the double digits in the late 70′s and early 80′s.
I prepare for risk by planning and planning and planning some more.
@Dominique-Yes, that’s my strategy as well. I like the illusion of control!
I would like so very much to comment about career risk along with a few other matters related to employmet and education.
The first thing is this I am a fairly intelligent person but I have never been able to develop a concept of what the job market is really all about.
Yes I know that theirs jobs that are skilled as opposed to unskilled. But here’s the thing how does one define what skill is’ for example a janitor is clearly a unskilled job or very low skill job and a dentist with twenty years under his belt is clearly a high skilled job’ but what about everything else in between the two. Someone that drives a van and makes local delveries is clearly not as skilled as someone that drives a eighteen wheeler over the road. But is the job driving a eighteen wheeler really a skilled job or not. What about the head manager of a seven eleven would their job be considered skilled. What about a helicopter pilot. What about a car salesmen compared to a certified auto mechanic. Is the car salesman considered a skilled job or not. I could go on and on but I think you get the point its much harder to define what skilled is or isn’t. In other words where does one draw the line when it comes to skilled or unskilled.
Another area I would like to comment about is formal education. Yes its true that people with more education make more money than those with less education. But break it down a little bit and its not so clear. If I randomly select 100 college grades and remove the twenty highest paid grades from the list’ I would be willing to make a educated guess that those twenty highest paid grades make as much money as the other eighty combined. Remove the twenty highest paid college students and you might get a totally different picture of things.
What about this’ If we take two college students that are identical in almost everyway they majored and minored in the same area got the same grades same act and sat scores attended the same college or university with one exception. One of them is one or two credits short of their bachelor’s degree. The other completed their education and received their degree. Now its safe to say that the student without a degree is just about equal to the student with the degree. We could say that they both would be just as likely to perform as well in the same job yet the student with the degree would be considered better educated and more likely to be hired and receive more money than the student without the degree’ but really theirs essentially no difference between the two the difference between the two is just a technicality. In other words the difference between the two is more like a class distinction than anything else.
One other factor to also consider is this the type of person that attends college is more likely to be more intelligent and also more ambitious than the person that graduates from high school and just goes out and gets a job instead of attending college. So at least part of the difference in pay can be attributed to the qualities that I just stated. In other words a person thats very bright and ambitious whether they have just a high school deplomia or a college degree would be more likely to be promoted on the job simply stated bright and ambitious people are more likely to be promoted on the job than people that are not bright and ambitious and most of the people that are not bright and ambitious just attended high school. It just so happens that most people that are bright and ambitious attended college. Employees that are promoted will make more money that those that are not.
The third thing I would like to comment about is this’ ranking accounts for a significant amount of the pay difference between two individuals. Take two people that both work at two different banks they both attended the same college or university they both have the same years of experience they both took the same courses in school got exactly the same grades the same degree the same sat and act scores. They each have worked at the bank the same number of years. They both have equal experience in the same banking speciality. They both have performed the same tasks. They both do the same amount of work they both have six people working under them. Their job performance review is exactly the same. Everything between the two is equal with one exception Bank employee number one is a senior vice president’ Bank employee number two is a junnior vice president. Banks have always been big on titles. Employee number one makes considerably more money than employee number two and its entirely due to the different ranking and really nothing else.
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@Financial-You bring up a multitude of topics for discussion regarding career risk. Many of your hypotheses may be valid, but one would need to check out the research to find out if they are true or not. (ie take out the top 20% paid graduates and the remaining 80% income would equal the top 20%). Another point is comparing the future success of two individuals and one graduates from college and the other leaves a few credits short. The diploma represents not only the accumulation of knowledge and skills, but also the commitment to completing a goal.
The fact that smarter folks attend college, again, one would need to look at the research to see if this is true. It could have to do with family values supporting education over innate intelligence. And of course there are exceptions to every rule, so that every college graduate will not make more money than every individual without. My plumber makes well into the 6 figures, without a college degree.
Those qualities of ambition and intelligence are certainly important as well (as you mentioned). Of course, there is the element of luck which plays into career success, as you stated in your last comparison.
Thank you for giving us lots to ponder.
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Enjoyed your article on risk. I contend that investment risk and inflation are directly tied to our government. (Not controlled but usually triggered by government policies.)
We had sever economic conditions in this country in the late seventies and now since 2009. We should recognize that both periods followed long war periods for our country. Perhaps we should not be spending billions in Afghanistan. The news talks about the fiscal cliff. The issue is consumer confidence and the resulting business climate following an erosion of that confidence. If consumers stop spending or spend 10% less than usual we will have an economic disaster. A disaster not because of any “real” occurence but because of an arbitrary “news” type occurrence.
Wayne Melton
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@Wayne, Thank you for your insightful comment. Your remarks focus on the tremendous impact of mass public psychology on our economy. That is why the “economic indicator” of “consumer confidence” plays into the financial and economic news. And the field of behavioral finance as well address how our behavioral biases impact our actions. On a country wide note, fear can drive a recession just as easily as greed can propel the investment markets.
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