Life's Risky Balancing Act

In both life and finance, risk is often perceived as a daunting force, an element to be avoided, reduced and eliminated. However, the reality is that risk, when understood and managed wisely, can be a powerful catalyst for growth in terms of investments and achievement in life.

In this edition of "Interlinked," we explore the multifaceted nature of risk – the risks not taken, the risks that propel us forward, and how embracing risk can lead to significant personal and financial growth.

• Risk and Life
• The Risks Not Taken
• Risk as a catalyst for growth
• Implementing a Risk-Aware Strategy

Risk and Life

Risk, as defined by the international standard is the "effect of uncertainty on objectives." This concept of risk is not just a financial principle but a fundamental aspect of life. It's about the potential for both loss and gain, the uncertainty that surrounds our decisions and the outcomes they may yield. In life, we encounter various forms of risk – physical, emotional, career, and financial. Each carries its own set of potential rewards and pitfalls.

My personal journey with risk began early, with a decision made by my mother. She took a risk by allowing me to play football despite her concerns with protecting my fingers so I could… play the piano. But this decision set me on a path that would define my future. The risk of playing football led to a full scholarship at the University of Kansas. Despite the risk of a college career where I never left a mark, I chose to stay at KU and persevere, resulting in being named team MVP twice.

The professional choices I made were also steeped in risk. Drafted by the Calgary Stampeders, I faced a pivotal decision: take the risk of trying the NFL as an undrafted player (read: Monetary Gain) or playing in a smaller league to chase a personal dream. I chose the latter, a risk that eventually led to realizing that dream. This journey taught me that while risk can be daunting, it can also open doors to incredible opportunities and achievements.

In the financial context, just like in sports, decisions often involve weighing risks against potential rewards. Whether it's investing in the stock market, starting a business, or making a significant purchase, each decision carries potential outcomes that can impact our financial health. Understanding one's risk tolerance is key to staying the course. It's about balancing the potential for high returns with the possibility of losses and finding your comfortable middle ground.

As an investment advisor, I bring this understanding of risk to clients helping them navigate the uncertainties of financial decisions to realize their aspirations. Just as I took calculated risks in my career, I apply the same principles to financial planning. Let's explore how understanding and managing risk can help you achieve your financial goals.

The Risks Not Taken

In our office, the adage "no risk, no reward" holds a profound truth. The stock market with its inherent uncertainties exemplifies this. Historically, the US market, particularly the S&P 500 index, has offered an average annual total return of around 8% to 10% over most rolling periods of 10 years. This potential for growth is a significant draw for investors, yet it comes with the caveat of volatility. Even a well-diversified portfolio isn't immune to the market's unpredictable swings, evidenced as recently as 2022.

So, the key to navigating these waters lies not in attempting to time the market, an endeavor fraught with uncertainty, but in controlling what we can. This involves two crucial decisions. Firstly, one must commit to being a stock market investor for the long term, recognizing that a decade is long time. Secondly, adopting a disciplined approach is essential. Regular, emotion-free investments like monthly contributions help mitigate the risk of market timing and ensure a steady course through the market's ups and downs.

Understanding risk in the context of its utility is vital. The value of a risk cannot be measured without considering its utility – the gain it brings, or the profit required to yield a given utility. This concept, rooted in the understanding that humans do not perceive changes in wealth linearly revolutionized modern economics. This is easy to illustrate; the value of one more dollar for a person who makes $30 thousand is different for a person making $1 million.

Cumulative Prospect Theory (CPT), for which Daniel Kahneman won the Nobel Prize in Economics, further illuminates our relationship with risk. It posits that the pain of financial loss often outweighs the pleasure of financial gain. Coupled with the observation that people do not objectively weigh probabilities, CPT provides a comprehensive framework for understanding why people often shy away from taking risks.

This aversion to risk, especially in financial contexts, can lead to missed opportunities. The risks not taken – whether due to fear of loss, misjudgment of probabilities, or underestimation of potential gains – can sometimes be the difference between achieving financial aspirations and falling short. In understanding a client, it's crucial to balance the fear of loss with the potential for gain, understanding that the path to financial growth often requires navigating through the uncertainties of risk.

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we do not know. But there are also unknown unknowns. The things we don’t know we don’t know." - Donald Rumsfeld

Risk as a Catalyst for Growth

As much as we work to understand the past, the future is always uncertain so knowing the nuances between known and unknown risks is crucial. Donald Rumsfeld's famous quote perfectly encapsulates the complexity of risk. In my world, this translates to risks that can be modeled and understood versus those that cannot. It's not just about one's risk appetite – how much risk one is willing to take – or risk capacity – the level of loss one can tolerate without jeopardizing financial goals. It's also about how investors react to both known and unknown risks, which can often lead to irrational behavior.

When considering risk tolerance, it's essential to factor in the potential impact of unknown risks. They can cause the most significant upheaval, precisely because they are not part of our calculations or expectations. The challenge lies in preparing for these unknowns, in building a strategy that is resilient enough to withstand not just the storms we see coming but also those that appear without warning.

To illustrate, I love the story of Ken Jeong, currently host of “The Masked Singer.” A medical doctor turned actor, Ken’s career exemplifies the positive power of risk as a catalyst for growth. Ken practiced his standup comedy routines in med school, into his residency and was eventually urged to move his practice to LA. After enough time, practice and understanding of acting, Jeong took the leap with odd jobs and eventually landed his famous role in the “Hangover” and the rest, as they say, is history. Jeong's story is a testament to the idea that sometimes, the greatest opportunities and successes come from venturing into the unknown, from taking risks that may seem daunting at first.

Ken’s understanding of risk applies to financial planning and investment as well. Embracing risk, especially the unknown, can open doors to growth and opportunities that might otherwise remain closed. It requires a balance of caution and courage, a readiness to pivot when necessary and a deep understanding of one's own reactions to both known and unknown risks. By acknowledging and preparing for these risks, investors can position themselves to not only navigate the uncertainties of the financial world but also to capitalize on the opportunities that risks often bring.

Implementing a Risk-Aware Strategy

Implementing a risk-aware strategy in investment management is a nuanced process that requires a deep understanding of an investor's unique financial circumstances. It begins with a thorough assessment of the investor's risk need, which involves defining clear financial goals, and evaluating the present and future value requirements of the investment account. Crucially, it's essential to estimate the required rate of return and assess its feasibility within the current market risk environment. This leads to a critical decision point: whether to proceed with the current plan or revise the goals and savings rate.

Understanding an investor's risk-taking ability is another key aspect. This is determined by factors such as the investment time horizon and the liquidity need relative to the portfolio value. The availability of external income or assets to maintain living standards in emergencies also plays a crucial role.

Finally, assessing an investor's behavioral loss tolerance is vital. In truth, being an investment advisor is much more about psychology than many give it credit for. Sure, we need to do all kinds of investment analysis and financial decision making, but we’re also handling our client’s life savings. When it comes to losses, if you do not invest reflecting your client’s loss tolerance, they will not be a client for long.

To maximize a client’s assets, we align their risk profile with their personal goals and financial objectives. This involves values-based decision-making, ensuring investment choices resonate with the investor's personal values and long-term objectives. Paired with diversification, spreading investments across various asset classes to mitigate risk and balance the portfolio against market volatility. Together with regular portfolio reviews and adjustments in response to market changes and personal circumstances, we ensure the investment strategy remains aligned with the investor's risk profile and evolving goals; turning their financial aspirations into reality.

Conclusion

Risk is an inherent part of life and a crucial component of financial planning and by understanding and embracing risk, we open ourselves to new possibilities and pathways to success. Whether in personal endeavors, careers like Ken’s or investing, a well-considered approach to risk can lead to substantial rewards. Let's work together to identify, understand, and strategically manage the risks in your journey towards realizing your ambitions.

P.S. Remember, every great achievement was once considered a risk. Together, let's explore what risks might be worth taking for you.