Understanding risk

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Here’s the problem with risk: It’s important and few of us understand it very well, much less know how to control it or, better yet, how to use it to our advantage. Risk is like a shark swimming silently below you … in the middle of the ocean … at night. It’s invisible, but, nonetheless, it’s a threat.

Imagine that you are stranded at sea, waiting to be rescued. What kind of shark is it? How big is it? Is it hungry? Is it alone, or are there others? These would be good things to know if you were trying to handicap your odds of surviving until you can be rescued.

Like sharks, risks can be big or small, relatively aggressive or passive, somewhat harder or easier to control. Unlike sharks, however, risks are easy to underestimate, overlook or forget. To have any chance at effectively managing risk, you must do three things:

1. Identify the source of the risk.

2. Determine the significance of the risk.

3. Understand the nature of the risk.

When considering investment risk, investors tend to focus on the more immediate risk of loss than on the longer term risks, like inflation or return sequence risk. You should ask yourself if you have identified all the possible sources of risk in your investment portfolio. The vast majority of investors I encounter focus their attention and worry almost exclusively on avoiding the risk of loss. This is a serious mistake. If you define investing success in terms of your lifetime standard of living, there are many risks — in addition to the risk of loss — that can lead you failure. All of these — those that are obvious now and those that might cause problems 10, 20 or 30 years from now — must be identified if they are to be managed.

Once identified, you should assess the significance of each and every risk you face. The risk that a hungry shark might turn left during the next 10 seconds may be significant to a slow moving fish swimming 20 feet to the shark’s left, but much less important to you if you’re treading water 100 miles away. A left turn might increase the chance the shark will head your way, but the risk that this particular shark is going to attack you remains low.

Generally, risk can be assessed as a function of two variables: the probability that the outcome in question will occur and the size of the impact if that outcome actually does occur. In the case of the shark turning left, the risk to the fish is large since the probability of it occurring is high — maybe 30 percent — and the impact will be catastrophic if it happens. To you, however, the risk of the left turn is the same, but the impact on you is nil. Just in case it isn’t clear (which would be my fault, and not yours), the shark in this analogy is a security you own, the left turn is a losing day in the market and you are the poor castaway treading water.

Identifying all of the various risks you face and assessing the threat that each poses will allow you to focus your attention on those things that deserve it and avoid wasting your resources and worry on those that don’t. Your attention and effort is best focused on learning about each of the important risks, how each works, behaves and responds to change. This means you’ll need a thorough understanding of the rules of the game you’re playing and how those rules interact with and affect the risks you face.

I have observed an epidemic of unmanaged risk plaguing the world of individual investors. Unrecognized, misunderstood and ignored risks run rampant. Judging by the various statistics for, and complaints from, Americans who say they can’t afford to retire the way they’d like, the problem of investing failures is pervasive and potentially devastating.

As the federal retirement system continues to evolve — or devolve — prudence demands that its beneficiaries step up to take responsibility for financial risk management upon themselves. Like unseen sharks to a floating castaway, risks to an investor should never be out of mind — or underestimated.

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