When most people think about risk in an investment context, they think of one thing: losing money. What most of us never stop to think about is why. Why are we afraid of losing money?
I’ll admit, at first glance this seems like a dumb question. No one likes to lose money, so that must be risk. But by digging deeper we can reveal the true nature of risk. If we can understand what risk really is, then we can both manage it and our own psychology better.
No one invests for the fun of it. We invest with some end in mind. We invest in order to accomplish our longer-term financial goals. Risk, then, is different from market ups-and-downs (which is the classic academic definition), and it is different from just “losing money.” Risk, at heart, is the probability that you do not achieve your goals. It is not that losing money is uncomfortable in and of itself. Rather, we don’t like losing money because it means we are less likely to achieve our goals!
This is a fundamental realization of goals-based investing, and it leads to a few differences in how we at Directional Advisors approach money management.
First, it means that we can quantify downside risk in your investment portfolio. What market losses would derail your goals? When are investment losses too much? Rather than guess at the answers to these questions, we can calculate them. By calculating them, we can take steps to mitigate the risk of unrecoverable losses in your investment portfolio.
This also leads to better management of our own psychology. We are afraid of investment losses because we don’t know if we can recover in time to achieve our goals. That is why all investment losses feel like too much. By quantifying downside risk, we can better understand when it is appropriate to worry and when market downswings are within our tolerance. Furthermore, by taking steps to mitigate the risks of excessive investment losses we can even further decrease the amount of worry. While there are no guarantees in life, this can go a long way to easing our stress about investing.
Second, this fundamentally changes how we organize our investments. Portfolios are put together in a way that maximizes the chances of hitting your goal. While your risk tolerance should be part of the conversation, it should not be the primary metric for managing your portfolio. Imagine going to the doctor and getting a battery of tests. Your doctor explains the problem but informs you that she cannot proceed with the necessary treatment because the pain-tolerance questionnaire you filled out at intake indicates that you are too conservative to proceed! While your comfort with market volatility is a part of the conversation, it should not be the only deciding factor in your investment portfolio.
Third, goals-based investors can recognize that markets are not tame. There are moments when markets can erase years of saving and sacrifice. We need to recognize that risk up front and take steps to mitigate it in your portfolio. We believe there are times to be cautious and times to be more aggressive. What to do when is determined by our outlook for markets, and also the specifics of your goals.
In the end, investment risk is perceived and managed through the lens of our goals. By better understanding what risk is, we can better understand how it should be managed.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.