Risk is a constant presence in our lives and in our wealth-building efforts. But what is risk, really? How can we be aware of it? Should we avoid risk or harness it? Lots to talk about in this blog series: Ultimate Guide to RISK.
Risk is misunderstood an incorrectly feared, or at best avoided. In this post, I want to focus on the risks you really need to be aware of, and you may be surprised at some of the things I say, or you may not!
Understand the Basic High-Level Risks for Wealth-Builders
Risk is everywhere and it is multi-faceted – it comes in many different forms, you could say. I’ve mentioned many of these before, and I’ll link to a couple of previous sessions on risk so you can explore further if you want to.
Inertia risk is one key risk. The risk that you’ll do nothing, and in so doing, miss out on opportunities. Inertia often comes from too much choice, or too much financial knowledge but not having the wherewithal to actually press the button and get your money invested.
FOMO risk is always wondering about the next big thing. These are the people continually asking about Bitcoin or other crypto, or wine investments, or the finer points of what a SSAS might do for them, when instead they could be actually investing in stuff they know works.
Many investors fear the risk of total loss, when this is a minuscule risk if you set things up right to start with. We’ll talk about diversification later, but if you’re investing in equities for growth, and you spread your money over hundreds or thousands of companies through a collection of funds, then to lose everything, every company in the world, pretty much, would have to go bust.
We’re talking literal Armageddon or fraud on a monumental scale. But you know what? Really there are four BIG risks that you need to be very familiar with because in so doing you can put that familiarity to good use and give yourself an incredible advantage. Let’s look at them one by one:
Big Risk 1: Incorrect Estimations When Planning
Any plan, financial or otherwise, is wrong the second it’s written because it is based on assumptions and estimates. I tell my clients this all the time. But a plan is still useful because it helps to set a trajectory, and that in turn informs immediate decisions.
Those assumptions are hugely important though, and particularly if you’re planning over decades, as most of us are. Half a percentage point difference in your assumption on inflation, or growth rates can mean the difference between your latter years being spent in plenty or penury.
It isn’t just numerical assumptions used when plotting spreadsheets or the kind of planning software that I use in my day job. Any assumptions can be VERY wrong sometimes. Like the assumption that you’ll always be able to work. What if your role is replaced by machines? Or what if you get ill? What if your planning is based on you staying married, and instead you get divorced? Some things you can’t take out insurance against!
Big Risk 2: Market Risk
Market risk is a broad spectrum of perceived risks in the minds of investors. It can range from concerns about total loss, like we mentioned earlier, to volatility – the range of returns you might get and the up-and-down journey along the way.
My colleague and respected financial planner Eugen Ngeau defines market risk as the risk that the market will not deliver the return needed to achieve your objectives. I really like that way of looking at it because it starts from the point of defined objectives – we’re potentially back to planning assumptions again – and wonders what will happen if the market doesn’t live up to its side of the bargain.
This is a very real risk because we can’t control markets. But we can control, to a point at least, the way in which we position our portfolios to benefit from market movements. We can constrain the impact of market risk by following some fairly simple rules for portfolio construction and management.
We’ll explore some more risks in the next post.
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