How Do You Like Risk?

How Do You Like Risk?

With the S&P 500 Index dropping 3.5% in the first month of 2014, this is a good time to think about financial risk. Some media spokespeople were asking “How do you protect yourself from the slide in January?” This implies two assumptions:

  1. That all risk is somehow avoidable
  2. That short-term losses are important to avoid

A better question is, “What will January 2014 mean to me in 30 years? (or 10 or 20)?”

To be alive is to live with risk. Life is risk. The fictional character in literature and film, Zorba the Greek, said it this way: “Life is trouble, only death is not.”

Of course, there are ways to manage financial risk. For example, while the stock market declined 3.5% in January, the bond market gained 1.5%—so a balanced portfolio with some bond exposure fared better in January than a pure stock portfolio.

Most investors do not have a well-grounded investment plan or strategy. They don’t do the work (in many cases because they do not have the skills) to know how much is enough for them over the period of time they will be drawing income from their portfolios. Math and strategy tools exist to ground these important conclusions. These tools help to establish the minimal financial risk an investor needs to take to achieve their goals. It is impossible long term to preserve the purchasing power of your dollars (to beat inflation) without assuming some financial risk, without experiencing some periods of loss like January 2014. The skill is to know how much risk you should take to make your life work.

The January 25, 2014 issue of The Economist leads with the headline: Why some people like risk. The article posits that risk-taking in America is at a low point because of the emotional trauma caused by the Great Recession of 2008/2009. The Economist grounds this conclusion from data showing that the number of self-employed workers has declined, job creation from start-ups is down, and direct investment in business is low.

This situation is serious because long-term economic growth is driven by people willing to risk all they have in a start-up enterprise or in the bold expansion of a business already on the ground. Academics in behavioral finance like Ulrike Malmendier at the University of California, Berkeley and Stefan Nagel at the University of Michigan, have found that people who experienced high returns from the stock market early in life have a higher risk tolerance and appetite for stock market risk later in life. On the other hand, people who have been traumatized by financial losses or natural disasters demonstrate a very low risk tolerance.

The Economist concludes that the 2008/2009 financial trauma is likely to inhibit a wide range of people in America and Europe from financial risks that would help grow the economy and help get their lives back on track.

What do you think about risk in general and risk in particular in your own situation? Do you have a long-term financial plan for your future? Do you know the degree of risk that is right for you?

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