When most think about the term risk, the feelings of anxiety bubble up and many tend to jump to worst-case scenarios. This is somewhat ingrained in our DNA as a self-protective mechanism. But I think it is helpful to simply define risk for what it really is, the uncertainty of outcome…negative and positive. I have spent my entire life thinking about risk and trying to navigate decision-making in the face of it. My experience has taught me a few critical things that I believe will serve investors as well as everyday adventurers.
Growing up in Mississippi, my parents were unique individuals. My dad “left a real job” with the phone company to pursue his passion to own a motorcycle dealership. My mom, likewise, was fully supportive of what was an uncertain future; being an entrepreneur means nothing is certain. Additionally, my dad liked racing anything with a motor, including dirt bikes and race cars. It is no wonder that as a kid, my familiarity and comfort with risk were maybe different than others. When I wanted to ride skateboards, race dirt bikes, or launch a jump on our annual snow skiing trip, I never remember being discouraged at all. It wasn’t that my parents didn’t care about my safety, but their comfort with these risks was simply different from others. Today, I still love to ride dirt bikes, mountain bikes, snow ski, and my most recent additional hobby is rock climbing. Interestingly, my parents were conservative in many respects and because they were entrepreneurs, every dollar was hard-earned, so their approach to money was not as “risk-taking” as others. My adult life likewise led me to entrepreneurism, but because money was tight, my views on financial management and risk-taking with money were similarly pretty conservative.
This leads me to my first point; someone’s upbringing and background have a profound impact on how they perceive risk. Additionally, how someone perceives one type of risk (physical) may differ greatly from how they view others (financial or social). One of my favorite rock climbers, Tommy Caldwell, who has done many death-defying feats, has expressed fear about public speaking about his feats…this is clearly an extreme dichotomy akin to a Navy Seal being afraid of spiders!
Risk is synonymous with uncertainty. If we knew the outcome, there would be no risk. If you knew with 100% certainty that Prickly Pete would win the horse race, then you would certainly bet every dollar you have on that outcome. However, as we all know, nothing in life is certain…we live in a world of risk.
The best we can do in risk assessment is to understand two important components: the probability of something happening, and then the impact or consequence of something happening.
For most activities and events, there is some semblance of a calculation of probability. Whether we are talking about the probability of being attacked by a shark, being in a car wreck, or winning the lottery, there is enough data to have a rough estimation of the probability of the event happening. The investing world is a playground for statisticians as the entire market is a confluence of numerical data to help measure risk. I think there is great merit in trying to estimate and quantify probabilities, not that they will ever be perfect, but to help at least understand what the “big risks” (highly probable) are versus rare risks. When trying to ascertain the probability of a risk, one key step is to clearly define the action. For example, when looking at the possibility of a fatal plane accident, you need to really clarify, is it a commercial jet or private plane, or is the weather or pilot experience taken into account? In the investing world, people think about the probability of losing money on an investment but may leave out important clarifications that are needed. Is the investment public and widely held or is it a private investment? Most importantly, over what time frame? Imagine a one-day investment where the probability of losing money is 50/50. If the time frame for this same investment is spread out ten or more years, the probability of loss could change to less than 10%. Properly framing the question is critical to accurate risk assessment.
The second part of this exercise is understanding the impact or consequence of an action occurring. A famous analogy is that of Russian roulette, where you have one bullet in the cylinder of a revolver. There is a one in eight chance of having a bad outcome, but in this case, the impact or consequence of being wrong is certain death. So, while the probability is only 12.5% (1/8) of a bad outcome, the consequence of doing so is not something anyone should ever do. The point of this outrageous example is that probability is important, but impact is also very important. We often focus on the probability, not the impact, or vice versa; however, both are important. If we overemphasize the impact and not the probability, we may never fly in a plane, drive in a car, or invest in a stock, because there is a non-zero probability of a really bad outcome. I’m sure everyone has at one time thought about the risk of driving on a two-lane road, but because the probability is low, we have learned to accept it as a part of everyday life.
While it should be obvious to most investors, it bears repeating: risk is closely linked to reward. Oftentimes, the more risk or downside, the greater the potential reward. However, for some, risk appears like a one-way street that leads toward loss.
In investing, and I believe in all parts of life, we should try and view risk objectively, but not apart from the potential rewards. For example, there may be financial risks to starting a business or investing in stocks, or relationship risks in pursuing a spouse, but uncertainty can and does have an upside!
Another interesting aspect I’ve observed is that most people don’t fully appreciate the risks they are already taking every day and, likewise, may overemphasize other risks. Our background, life experiences, exposure or familiarity, and knowledge about a risk greatly influence our ability to assess the probabilities and impacts to accurately assess risks.
For example, I mentioned earlier that one of my hobbies is rock climbing. Some people, when they hear that, immediately get sweaty palms. However, this is where specifics are crucial, and understanding the type, method, and other factors matter greatly when discussing the risks involved in rock climbing. When I first got interested in the sport, one of the initial things I did was to read up on rock climbing accidents, which have surprisingly good statistics. This helped inform me of a few types of climbing that would certainly be unacceptable to me. Alpinism in remote high-altitude areas with snow (think Everest, K2, etc.) is a very high-risk endeavor. There are countless things that can and do go wrong all the time, making it extremely dangerous. Sport climbing, which is my favored style, isn’t basket weaving but is overall safe. When analyzing sport climbing accidents, most included situations where climbers ignored simple rules about tying knots correctly or climbing in bad conditions. Much like driving a car, if you wear your seat belt, don’t speed, and keep your eyes on the road, it can be highly safe and enjoyable. But if you don’t follow basic rules, rock climbing or driving a car can be dangerous.
Our perceptions and formulations about risk are biased, whether we like it or not. The people you hang out with, what you do for a living, and importantly, the media you consume greatly affect your decision making. In the financial world, we see this on full display regularly. For example, we have incredibly successful clients who made their millions in real estate. Their familiarity and expertise make them comfortable using large amounts of debt to build their wealth. For other investors, this approach would seem absurd. To further complicate matters, the media seems to operate on the “if it bleeds, it leads” mentality of reporting the news. News in general is filled with negative coverage and financial news in particular has a hefty dose of hyperbole, leaving many people more fearful of the investment markets than if news coverage was accurately reported. While many recognize the overall positive history of the stock market and the wealth creation it has enabled for millions of people, this perspective is often lost in daily news reporting.
Risk and our perceptions about risk lead to fear. Fear clouds our emotions and inhibits our ability to think properly, which is rarely a good thing.
While we should have a healthy respect for risks, operating on emotion, especially in the financial world, is almost always negative. It may be easy to say, “don’t be fearful”, but it is harder to do. This is the unique fun of rock climbing for me. Contrary to popular belief, rock climbers do get scared…albeit it takes more to get our blood pumping than a non-climber. One of the main challenges in the sport is to accurately assess what is real danger and what is just perceived. If you have done everything correctly, you have a good rope, your harness is on securely, and your partner is belaying you and ready to catch you if you fall, then the fear you feel is mostly based on a false perception of danger and should be ignored. Again, this is easy to say, but it takes time and effort to build trust in these systems. There are still times of actual danger, when you must be careful or when fear should be acted upon, but most of the time the goal is to ignore your emotional reaction and focus on your rational brain. Recognizing the difference and learning to cope with your emotions is a huge part of the challenge and fun of the sport. Similarly, Warren Buffet famously tells investors that you should be “fearful when others are greedy and greedy when others are fearful.” This is the financial equivalent of telling yourself to focus on the rational and not the emotional, as the emotional response when investing is often the wrong response, and as an investor, you could be rewarded for actually doing the opposite.
We should aim to have our eyes wide open to the world we live in, a world of risk. Being a student of history in general, market history in particular, and developing a skeptical ear when listening to “alerts” and “important news” are all good admonitions. Recognize that we are all biased when assessing risk and need to assess the actual probabilities and impacts, and not just let our minds be influenced by fear. Fear is a very powerful emotion that can inhibit our ability to accurately assess our options. To be clear, I do not believe it is possible or even healthy for people to become robots or human calculators.
Our feelings about risk are as unique as our fingerprints and each person needs to make decisions the way they see fit. My encouragement is that each person needs to be open to being educated on a topic, assess the risks, and make a decision that makes sense for themselves.
When you don’t let fear control you, but rather commit to being more rational, the result can be an increased level of ownership over your decisions and a wonderful feeling of empowerment.
One final encouragement is to not go through this exercise alone. Whether it’s rock climbing, starting your own business, or making financial decisions, it is advantageous to have a guide to help provide the information, experience, and yes, even the emotional support to assist you in making the decisions that are right for you. While financial advisors aren’t psychologists, we do recognize that money decisions come paired with emotions and that our job is to provide the context and education to empower clients to make decisions.
Bridgeworth Wealth Management is a Registered Investment Adviser.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
The information and material presented in this commentary are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this commentary. Investing in any security or investment strategies discussed herein may not be suitable for you, and you may want to consult a financial advisor. Nothing in this material constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance.