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A recent post by Dick Quinn asked an important question in personal financial planning – “do we understand our risk tolerance”. The post linked to an investment risk tolerance assessment. I took the assessment twice and received a similar score each time – an average/moderate tolerance for investment risk. I’m wasn’t surprised by the score, especially now that I’m retired.
Risk tolerance describes our “psychological willingness to take on risk”. Although there are likely some inherent aspects to our risk tolerance, I believe we can evolve our understanding of financial risks through education and experience. This can help at both ends of the spectrum; a very risk averse person may come to better assess investment risks and make reasonable choices, and a high-risk gambler may back off and take a look at index funds.
Although it’s important to understand our tolerance for investment risk, I think it’s more important to understand our risk capacity. Risk capacity measures our ability to handle financial risks. Our risk capacity includes things like our income, assets, debts, and insurance. It could also consider our human capital, or our ability to work and earn income. A married couple with two high earning professionals likely can assume more investment risk than a family with a single earner. But if both earners work at the same company, they might share a risk of the business closing. This happened to a number of couples I worked with during several mergers and plant closures.
The good news is we can improve our risk capacity by practicing sound personal behaviors. These are the behaviors we read about every day on HumbleDollar. They include working hard, growing your skills, living within your means, saving, investing, insuring, and leading a healthy lifestyle. More good news – these are activities we can mostly control.
Risk management was an integral part of the many complex projects I supported and led during my career. It’s also important in personal financial planning, and we can tailor it to our specific needs. It’s hardly an exact science, but the process of identifying, analyzing, evaluating, acting on, and monitoring risks is a big step in moving us to a secure financial future.
Warren Buffett, while speaking to a group of MBA students at the University of Florida just after the collapse of Long Term Capital Management in 1998, said something about risk I’ll never forget because it applies to so much more than financial risk. He said the guys at Long Term, “…risked what they did have and did need for what they didn’t have and didn’t need.”
Nassim Taleb, is his last book, “Skin In the Game”, talks about sequence of risk in his last chapter. Bottom line is never take risks that may result, as a potential outcome, in total ruin. Long Term did just that. Then there was the fellow who passed me riding a crotch rocket motorcycle on I-95 in Jacksonville, FL, about ten days ago, driving between the cars/lanes at about 100+ mph. He didn’t get the memo about avoiding activity that can lead to total ruin.
Patrick, thanks that is one of my favorite Buffet quotes. It reminds me of when I was a young engineer. We had a group of guys that had a monthly poker game. We would alternate hosting the game. We were all in the beginning of our career, many of us with a young family. The stakes were very modest. One of the guys older and wealthier brother-in-law asked to join the group. He kept pushing the stakes to the point where the pot was more than I was comfortable with. It was money I “did need”, and I s(and a few others) topped playing.
You see this sort of thing with guys who seem to have it all, career and financial success, a nice family, etc. then they go and have an affair, get divorced, become estranged from their children, sometimes destroy their career, and get a whole lot poorer all over a really bad decision. Throw in a little alcohol and the odds go way up. (Why do casinos serve gamblers cheap or free drinks?). There is a rubicon there you don’t want to cross if you can help it.
The other thing to remember about risk propensity (from psychology research – especially escalation of commitment research – instead of bailing now to preserve what you have left you risk it all in hopes that you will get back all that you have lost so you don’t bail) is that when we look at things from the point of view of a loss or potential loss (eg are loss framed) we are more likely to take a risk/bigger than when we look a things from the point of view thinking about something as a gain/potential gain (eg are gain framed).
If there actually has already been a loss and we focus on the loss we are more likely to stay on that path and take a bigger risk to try to get it all back than if we view it from a gain framed point of view of if we bail now we will not lose more money in the future thus will gain that.