Given that the groundhog saw his shadow and we should therefore expect 6 more weeks of winter, it may be a good time to talk about RISK. Risk is a multi-faceted, multi-dimensional subject. Financially speaking, risk has 4 primary aspects:
Risk Required: Rate of return needed to achieve financial goals.
Risk Perceived: How risky something “feels”. Skydiving seems risky; the stock market seems more risky than a few years ago.
Risk Capacity: This is the amount of risk that one can afford to take. A billionaire can afford to take some risk, suffer a loss, and still buy the groceries. Risk capacity is an absolute, financial measure that overrides risk required and risk perceived.
Risk Tolerance: Tolerance is psychological and expresses how one feels emotionally about taking risk. It is not the sole determinant of behavior since risk perception also plays a role. Risk tolerance is the most challenging aspect to measure. Our firm accomplishes this using the Finametrica Personal Financial Profile.
Risk required generally must be a rate of return at least equal to the inflation rate (historically 3% to 4%) in order to maintain purchasing power. The risk required rate of return generally must exceed the inflation rate by at least a few percentage points in order to accumulate financial wealth and meet long term goals. Many people might like to take zero risk (bury cash under the mattress), but then inflation will erode the value.
There is frequently a gap or conflict between the 4 primary aspects of risk (many investors want a high rate of return but have high risk perception or low risk tolerance). Furthermore, as risk capacity declines after periods of investment losses, risk required may increase absent any changes in goals. A process commonly called Gap Analysis must be employed to resolve the conflict between different aspects of risk and will typically lead to one or more of the following decisions:
A. Increasing resources available through earning more and/or spending less.
B. Converting personal use assets to investment assets.
C. Easing the goals thru delaying, reducing or eliminating goals.
D. Take somewhat more risk than preferred, but not so much to cause panic.
We will be discussing and highlighting the complex subject of risk more in the future. Stay tuned! |
