One tends to think of Risk in the negative … all risk is bad.
But, that is simply not true. In fact, the fundamentals of finance are based on a risk-return trade-off where higher yields are theoretically paid for higher levels of risk. But, we are getting ahead of ourselves …
Risk is uncertainty. You enter an unknown situation, like the proverbial fork in the road. You don’t know where either path ends and what you may encounter along the way but there is something intriguing about each of the directions and you make a choice to go to the “right” or to the “left” (no, no politics please).
As you walk the path, you enjoy the scenery. Maybe you trip over a root bulging up from the ground and skin your knee. Maybe the weather changes and you get wet or chilled or very hot. But the sky is blue much of the time. And, ultimately you reach some destination and you are happy for completing the journey, despite some of the trials along the way. You’ve met the challenge and achieved the destination. At the end, you ask yourself, “was it worth the risk”? After all, you just selected one unknown path. There was uncertainty.
Now, some would come to the fork in the road and be completely unphased by the choice of selecting between two unknown paths. Let’s call these people “risk takers”. They are completely at peace with the possible outcomes and/or completely oblivious to them as well (like children who run out into the busy street).
Others will come to the fork in the road and face complete paralysis. They have no idea of how to even choose a path and are completely terrified by the prospects of either. They see only the possible harm that could come to them, they see dark skies, bad weather. These are the “risk averse”. I would not call them irrational … in fact there may be good reason for their reaction … perhaps bad previous experiences on a forked path. But there are people out there who cannot leave their homes (agoraphobes, for example) and there are those who are just a bit above these folks in risk taking … they keep their money in their mattress, they never venture on to the freeway, they never leave their neighborhoods. They are comfortable in the familiar.
Most of us are somewhere in the middle of this risk “continuum”. We are comfortable with some risk, but aren’t likely to bungee jump (except in the Amazing Race when a million dollars might be on the line). We travel to foreign lands occasionally, but like our old standby locations too. We come to this fork in the road and we do a bit of investigation. What can we see down either path? What is the weather like now and what is the forecast? How much time do we have to explore? Do we have extra water, maybe a jacket, sturdy shoes on? This is essentially saying that we are willing to take risk, but risk that we are “prepared” to take. In other words, we have done our “homework” and have gotten comfortable with the possible outcomes. We have assessed the risk.
So let’s quickly apply this “fork in the road” example to our normal lives. We just got a bonus from our employer. We could (1) spend it, (2) save it, (3) invest it, and (4) do a little of all three.
Our personal risk assessment, knowing our risk appetite, goes something like this:
How stable is my current financial position – do I have a budget? do I have sufficient savings? are my credit cards and other debts paid off or manageable? If there are “gaps” between where you should be and where you are, use some of your bonus to bolster these areas. This is necessary, especially for the “risk averse” in us.
Is my job stable? Are there layoffs in my company and/or in my industry currently or likely? Are there regulatory or governmental changes likely that could change my job? Do I like my job and am I likely to stay with the company I work for, given my choice? If a job change is in your future, put some of the bonus money into bolstering your savings and perhaps into career counseling, resume services, etc. Looking for a job in this economy is taking a bit of risk … unless you are already unemployed or just so miserable in your job that your mental health needs you to take that risk. But you are not blindly taking the risk.
Where am I with regard to saving for retirement? Am I participating in the company’s 401K? Is there a match? Am I maximizing the match? Have I lost money in my 401K and do I need to change investment choices? Use some of your bonus money here and/or allocate some future paychecks to bolster your contributions. This is also for the risk averse.
What are my financial goals – tuition? a new car? a house? is a special event upcoming? Do I have the money saved for these and/or am I on pace to have the money saved for when it is needed? Identify “gaps” and fill in with the bonus money, where needed, or change savings patterns in the future. This is a good combination of risk averse thinking and taking a bit of a risk. Any big expense is taking a risk, generally.
Given your short and longer term financial needs are met, you are able to look into some investment options.
Is my savings in a solid financial institution? Am I getting the best return possible? Is my local credit union an option? What kinds of choices are in the marketplace for CDs – interest rates and terms? Do I need some of this money at a finite point in time in the future? Is there a fixed investment that I could time to come due when I need the money? This involves a bit more risk because you are exploring the options of tying your money up for some finite time periods. There might be a penalty if you put your money in a CD but then need to get the money out early.
Do I have an investment portfolio? Am I happy with my returns? Is my portfolio diversified? Am I educated about my investment choices and do I understand how to invest and what I am invsested in? Am I using a discount broker and am I getting the cheapest transaction rates possible? Have I done research into this investment? This is for the risk taker.
Or maybe that pair of shoes is “calling your name” … now that might not be risky behavior but if your financial needs and goals are met and you “blow” your bonus on a new $500 pair of shoes, I’d call you a risk-taker too.
Ultimately, you will come up with an assessment that looks at your plans and allows you to make educated decisions on where to put your money and where you might have excess money to invest.
Hopefully, you now have a better understanding of Risk and how you can manage some Risk in your life.