Broker Check

Risky Business

November 15, 2023

What Is risk? Do you take risks? Do you know where you have risk?

To many of us, risk is just another four-letter word. It may just represent a mysterious obstacle to success. Risk broadly, means exposure to the possibility of a loss or a hazard1. Despite this seemingly simple definition, risk often feels like an ethereal term – an abstract concept - as opposed to a real and present one. Therefore, sometimes we may take risks that we don’t identify as risks.

We make decisions all the time based on our assessments of various risks. When financial advisors address risk, it often begins and ends with a discussion of investment-related risks, and only investment-related risks, such as volatility risk, inflation risk, interest rate risk, liquidity risk, etc. However, these risks do not represent the universe of risk…and should almost never be the whole story in the pursuit of a financial plan. In fact, investment risks may make up such a narrow portion of the world of risk, that plans limited to this discussion may miss the big picture.

There are risks other than investment risks that we face in life which we may need to consider in making decisions. Many of them may interact with each other and collectively impact our ability to achieve our ultimate goals. Due to these interrelationships, making life planning decisions in a silo -- considering just one type of risk to the exclusion of others -- can result in poor decisions informed by incomplete information.

Unfortunately, making decisions in silos is very common – even important decisions.  We all probably have a history of making decisions and implementing advice with different advisors (financial, legal, medical, other) at different points in time, for different reasons. How often have you stopped to ask yourself – or anyone else -- whether each decision you are making meshes well with others you have made previously?

Examples of some (but not all) other risks that may be worthy of consideration may include:

  • Lifestyle maintenance or cash-flow risk: Unless you are fabulously wealthy and/or live as if you are impoverished, at some point, at some age, cash-flow projections may illustrate that you may not be able to sustain a particular inflation-adjusted lifestyle. For some of us, that age maybe very old, but for others that age may be well within our life expectancy and uncomfortably soon.

What is your comfort zone with the prospect of running out of money? Would you define success as having greater than a 70% chance of an annual $100,000 inflation adjustable sustainable lifestyle at your age 90? If not, how would you define lifestyle maintenance success and how would you arrive at such a definition? Would you downsize your home or move to another state to increase the probability of success? Would you choose maintaining a desirable lifestyle over leaving a legacy as a strategy to increase your probability of success? Would you consider the need to downsize or reduce your legacy a failure?

  • Health risk: Notwithstanding your investment planning and analysis of your projected “probability of success,” what about the risk that your health may fail making you too sick or infirm to enjoy that “success”? What about the risk that poor health may result in an earlier than planned retirement? What about the risk that an adverse health event may result in much greater than assumed expenses as well as reduced income?

A subset of health risks may be referred to as “frailty risk”which many people may not like to think and talk about3.  John’s Hopkins definition of frailty may be met by more than 25% of those over 84. Frailty increases the risk of illnesses and falls as well as the cost of monitoring and treatment4.

Are these issues factored into the “probability of success” formula, or more importantly, into your decision-making process?

  • Climate risk2: The risks to person and property of the increasing severity and frequency of extreme weather events have resulted in new laws and regulations which may impact our current spending choices, as well as where and how we may live and travel in the future. Have you considered whether you might incur either short-term or long-term additional costs as society shifts to “greener” technologies? What might the potential impact of climate change and its regulatory environment be on your definition of success and the probability of achieving it? How are these issues factored into your decision-making process?
  • Inertia risk: Inertia is a property of matter by which it remains at rest or in uniform motion in the same straight line unless acted upon by some external force5. Similarly, inertia risk in the financial planning and decision-making universe seems to exist as the “tendency of humans to stay with a previously made choice, independently of the initial decision’s outcome6.” Behavioural finance recognizes “inertia bias” or a “status quo bias” in describing resistance to change7. The risk of this bias in the clinical medical field is that it might contribute to inadequate chronic disease care8. In the financial planning field, it might inhibit people from engaging in planning, even though they know it would be good for them9.

Do you have some important planning decisions to make and seem to be stuck in neutral?  Are you slightly overwhelmed by the perceived complexity of the many disparate elements that might need to be considered? Are you fearful of making a mistake or just confused?  Do you need that external force, or a nudge, to re-ignite some forward progress? How is inertia risk and its impact factored into your decision-making process and in assessing your probability of success?

Regardless of whether your goals are funding retirement, leaving a legacy or something less ambitious, does your current plan define what constitutes success and failure?  What about all the possibilities in between success and failure?

In 1955, Herbert Simon first proposed the idea of “bounded rationality.” The boundaries to our rationality in making decisions according to this view include cognitive, temporal and bias limitations. Risk is personal. Humans are not data-processing machines so some simplifications are required. We sometimes tend to make decisions quickly and without complete information because we make assumptions about what we do not know. This can result in implementing something less than optimal solutions10.

What’s the answer to good decision-making? In my opinion, the answer is to employ a process:

  • Identify and quantify your objectives – if you cannot articulate them or measure your progress to them, how will you know when you are successful?
  • Prioritize your objectives – in the event that not all objectives can be fully achieved, which ones are you most willing to reduce or possibly eliminate?
  • Identify the resources available to help achieve your objectives – what is your starting point? Your current condition?
  • Identify the obstacles to your success and quantify the potential impact that may be anticipated along the way. Here’s where the risks described above along with any investment issues begin to be considered.
  • Identify the best way to deal with each obstacle or risk:
    • Eliminate it where possible.
    • Reduce it or its impact.
    • Insure against it or otherwise manage it.
  • Monitor your progress -- Objectives may change over time; risks may change over time; priorities may change over time.

I began this article with the implication that risk is an abstraction.  In reality, it is not.  We only perceive risk as abstract – a perception possibly borne from being overwhelmed by the interconnection of various risks. The goal of the planner is to be able to compute (to some degree) the ability or inability to achieve a particular objective. You cannot know if you’ve won if you do not keep score.

Although the solution process described above is logical, it is not necessarily easy – especially if you are trying to implement the process for your own planning. Planning requires an objective, educated and experienced 30,000 foot cross-disciplinary analysis of your current condition and how it changes over time. As a do-it-yourselfer, you might be able manage the implementation of some specific tasks, but it is less likely that you will be able to supply the dispassionate expertise needed for the initial “nudge” to begin planning and for an unbiased examination of the existence and collective impact of all the risks you might face going forward. Professional assistance in planning may be invaluable.

Please feel free to contact us if you would like to discuss risks that you face or how the planning process might work for you. We’re here to help.