How Much Financial Risk is Right for You?
The following is adapted from Stress-Free Money.
This is a true story I witnessed during my early years at a big brokerage firm. A woman walked away from her divorce with $2.5 million, which was primarily invested in one tech company stock, and it seemed to be going up in value each month.
However, this woman’s money didn’t last. She was enamored with tech stocks and was caught up in the hype. Her advisor tried many times to warn her about the risks of being too concentrated in one stock position. At the time, that allocation didn’t seem that risky to her, because she was making so much money. However, after the tech bubble burst and the decline in her account kept accelerating, she refused to believe it was really happening. She hung on until money was literally all gone. She had taken on way too much risk, and she lost everything.
At the other extreme, people often mistakenly assume that risk means there’s a chance an investment could go down in value. In fact, according to financial guru Nick Murray, the greatest risk you actually face is your money losing its purchasing power. If you stash your money under a mattress and lose ground to inflation, you will see how in the future your money might buy half as much as it used to, or more. Inflation is the silent wealth killer.
I’ve seen many stories from both ends of the spectrum—people taking on too much risk and gambling their family’s future as well as people sitting on the sidelines with idle and dusty money, watching the value of it slowly erode. The right way to approach risk—and the way that will take the most stress off your plate—is to find a middle path that suits your goals, age, and retirement plans. You can’t completely avoid risk, but you also can’t get seduced by financial hype. How much risk is right for you? Here’s some guidance to help you figure it out.
No Such Thing as “No Risk”
If you tend to always err on the side of caution, consider that you may not be as cautious as you think. Your financial habits might actually be causing unnecessary risk for the future. When it comes to finance, there is no such thing as “no risk.” Some risks are unnecessary, like the client who put all her money into one stock. Others, though, are inevitable, and no matter how careful you are with your money, you cannot avoid them.
Inflation risk is one of the inevitable ones. There’s going to be inflation over time, and you’ll have to deal with it. Market risk is another inevitable one; if you invest in the markets, there will be volatility. They’ll go up and down in cycles. You can’t completely avoid volatility if you’re looking for growth. It’s a simple fact that investing will be volatile.
That leads us to an important distinction. Volatility isn’t the same as risk. Volatility is the amount that an investment may go up or down in price. Risk refers to your exposure for danger. In other words, you may have a volatile investment that changes when the stock market dips, but it doesn’t make that investment fundamentally unsafe. Chances are, it will rise again in value.
If you’re constantly avoiding volatility, it’s going to come back to bite you. You could get a money market fund, a six-month CD at the bank, and some short-term Treasury bills. The dollar value of your account will barely fluctuate at all. You’ll get a little bit of current interest each year, which will be more than wiped out by inflation and taxes, but you’ll sleep like a baby. But, one day—and that day may not come for twenty years—you’ll run out of money. You actually needed some volatility to overcome the inevitable risk of inflation. When you’re evaluating your risk level, ask yourself, “Am I more worried about volatility or actual risk?”
Either way, one fact remains: you cannot control risk. However, you can manage and control how you respond to it, how you prepare for it, and how much risk you decide to take on.
Risky IPO Fails
Risk doesn’t always come with a bright red warning label. All too often, people take on risky investments without ever realizing it’s risky. Someone they trust has told them it’s a sure bet, or they heard on the financial news that x investment is going to pay off in a month. They think they’re being prudent, when unfortunately, they’re gambling with their hard-earned money.
That’s what happened when one of my clients who was in the habit of consuming financial media got excited about a particular company’s initial public offering (IPO). He wanted us to invest $50,000 of his retirement account in this stock that was soon to be available to the public. We told him the investment wasn’t in line with his goals, but we could make the small investment for him without it derailing his overall plan. However, as he continued listening to the hype, he decided he actually wanted to invest $500,000. That meant he’d be risking twenty percent of his retirement on a newer, unproven company.
My team and I tried to talk to him and his wife about the request. We tried everything in our power to help them see the risk far outweighed the potential return. After a full week of conversations, emails, and phone calls, we successfully convinced the couple the investment was not in line with their goals. He had real FOMO because all his friends were making big investments in the IPO. However, within the first two weeks, the stock was down sixty-three percent. He would’ve lost more than half of his investment in less than a month, when the money had taken more than a decade to accumulate.
As a financial advisor and professional fiduciary, I’m on the outside of the relationship looking in with objectivity and awareness of the larger plan. That’s important when it comes to evaluating your risk level. A neutral advisor can help prevent you from getting overly enthusiastic about a bad investment just because it seems appealing and exciting in the moment. For the best results, review your financial inspection with an objective, neutral, third-party fiduciary whose team has expertise in different financial planning areas.
Protect Your Hard-Earned Success
So, how do you assess what level of risk is right for you? The best way to do it is to get a neutral second opinion. Don’t trust your own overly cautious gut, because it might be leading you toward the invisible long-term risks of inflation. Don’t trust your pal who has the scoop on the next latest thing. Trust someone who can look at all the facts and decide objectively whether the returns are properly aligned with the risks.
A great fiduciary advisor needs to not only insulate you from short-term investment volatility, but also minimize your long-term regret and keep you from making big mistakes. Protect your hard-earned success by knowing what risk level is appropriate for you to take on, which you can determine by creating a detailed, goals-based financial plan.
For more advice on financial risk, you can find Stress-Free Money on Amazon.
Chad Willardson, CRPC®, AWMA® is the president and founder of Pacific Capital, a fiduciary wealth advisory firm he started in 2011 after nine years of climbing the ranks as an investment advisor at Merrill Lynch. Currently, Chad also manages a $350 million investment portfolio as the elected city treasurer in his community. He created and trademarked The Financial Life Inspection®, a unique process to remove the stress people feel about their money. He’s been featured in the Wall Street Journal, Forbes, Inc., U.S. News & World Report, Investment News, Entrepreneur, and Financial Advisor. Chad and his wife live in Southern California with their five beautiful children.