“Risk is the price of admission to achieving your long-term goals.”
Many people avoid investing in the stock market because they think it’s risky. They’ve been fooled! The culprit: the English language.
The word ‘risk’ is very similar to the word ‘risky,’ but the words mean very different things. ‘Risky’ is roughly synonymous with ‘dangerous,’ ‘foolhardy’ or ‘perilous.’ Robbing a bank is risky. So is driving your car at 120 mph.
Risk, on the other hand, is a mathematical concept. It has to do with probability—the likelihood of something happening. Risk is everywhere, even in places you can’t see. Breathing involves risk. Eating ice cream involves risk. Walking down the street involves risk. In each of these activities, there’s risk—some chance of a bad outcome however small: lung disease, choking, getting hit by a car.
There’s risk in everything you do. There’s also risk in everything you don’t do. There's risk in not eating a healthy diet. There’s risk in not exercising. There’s risk in not planning for your retirement.
Why You Can’t Avoid Risk
There’s also risk in not investing in the stock market. The risk of the market declining on any given day is 46 percent. But extend the timeframe to one year and that risk drops to 25 percent. Over a 12-month timeframe, in other words, you have a 75 percent chance of a positive outcome. You encounter risk in the market, yes, but investing in the market isn’t risky. In fact, it’s far riskier not to invest in the market.
If you don’t invest in the stock market, you are forgoing the long-term returns you need to achieve your financial goals. Forgoing those returns means you might not be able to sustain your lifestyle over the long term. It means you might be be unable to help your kids or grandkids when they need it, you won’t be able to take that vacation you’ve always dreamed of, or you’ll have to downsize to a less costly house.
Some people think they can completely eliminate risk by thinking about decisions and circumstances more carefully. This isn’t so. Some risks can’t be accurately measured because they can’t be seen in advance; others have an irreducible element of chance that can’t be banished. Author Carl Richards describes risk as “what’s left over after you think you’ve thought of everything.” Risk can’t be completely eliminated. It can only be managed.
The first step to managing risk is recognizing that it’s everywhere and can never be totally removed from your life. Every decision you make has a range of possible outcomes. You can’t guarantee that every decision will have a positive outcome. You can make good quality decisions but still experience bad luck. You can only evaluate risk and make decisions where a good outcome is likely.
Evaluating risk is an intellectual exercise. It involves things like looking at actuarial tables or market history and calculating the chances of various outcomes.
Evaluating what’s risky, by contrast, is emotional. Our emotions evolved as rapid responses to immediate environmental threats—to things that are dangerous. But they’re notoriously bad at helping us assess the likelihood of good or bad long-term outcomes.
How Emotions Make You Feel Risk
Emotions can make low-risk things feel risky. That is, they can make something very safe feel as if it’s dangerous. Take amusement park rides. They’re designed to feel dangerous even though they’re far safer than, say, driving in a car. The chance of dying on a roller coaster is approximately 1 in 750 million, according to the International Association of Amusement Parks and Attractions. By comparison, the chances of getting struck by lightning are about 1 in 250,000. The lifetime chance of dying in a car crash is approximately 1 in 107, according to the National Safety Council. In other words, you’re 3,000 times more likely to get struck by lightning than to die on a roller coaster, and 7 million times more likely to die in a car crash.
Yet when you’re riding the coaster, it feels dangerous—that’s how it’s designed to feel. It’s designed to trigger your emotions and create the illusion of danger while still being extremely safe. In fact, you’re far safer riding on the coaster than you are riding in the car to get to the amusement park.
Other things are designed to create the illusion of danger as well. Take the media. It aims at triggering emotion. What’s newsworthy is what stands out. Media outlets want to hook viewers. So, they don’t show ordinary things (e.g. a sprinkler on your lawn) because no one wants to watch that. It’s boring. Instead, they show the extraordinary, the shocking, the dangerous, and magnify it. As a result, a media diet based solely on TV or internet news creates a feeling of danger or threat that doesn’t accurately represent the real world.
The right way to manage risk isn’t to follow your emotions and allow yourself to be manipulated by people who are trying to trigger them. The right way to manage risk is instead to develop a decision-making framework that evaluates risks and rewards, and that aligns your investment choices with your long-term financial goals.
Why Risk Is Needed
Risk is the price of admission to achieving your long-term financial goals. Here’s an analogy. When you buy a concert ticket, you’re exchanging money upfront for the opportunity to hear your favorite musician at some future time. In the same way, when you invest in the market, you are exchanging money upfront for the opportunity to obtain greater investment returns at some future time.
One tried and true strategy for obtaining those returns is diversification—owning little pieces of lots of companies. Another is to follow the insights investors have gleaned from observing almost a century of market data.
We help you develop a decision-making framework that manages risk with the aim of achieving your long-term goals. Personal financial planning revolves around what’s most important to you. Our role is to provide guidance so that you understand the range of possible outcomes that flow from your choices. Ready for a real conversation?