Life is filled with decisions, and each decision comes with its own set of risks.
When making a decision it can be difficult to determine what risks you are comfortable taking. It becomes even harder when making decisions on topics you’re not well informed on.
When it comes to life, and specifically wealth management, how are you to determine your risk tolerance and risk aversion?
Below are some common definitions for risk as it pertains to wealth management:
- The chance that the actual return on an investment will be different from its expected return.
- Risky assets: An Asset with an uncertain rate of return.
- The possibility of losing something valuable.
- The variability in an investment’s rate of return.
Although these definitions are familiar, and seem to do a good job, they have three limitations in common:
- They all confuse measurement with a true definition or explanation of the concept of risk. To put it another way, they assume that a numerical measurement related to something is akin to an explanation of the concept. Risk is not such a simple concept that understanding its measurement is the same as understanding the concept.
- They all define risk as being purely objective and unambiguously measurable, when really it is a personal or social attitude toward something.
- They define risk in relationship to a single facet of wealth management, usually liquid financial investments (like stocks and bonds) or insurance.
A better definition of risk might be the probability that something will fail to meet your goals.
Although it might sounds similar to the definitions above or too simplistic, let us explain in greater detail.
In one word, the goal of wealth management is Happiness. However, happiness is probably even more difficult to measure. You could try by using hedon‘s, but that’s besides the point.
To achieve happiness through wealth management, people need to determine and clearly articulate their goals (as the definition above implies). To clearly articulate goals, the goals must have two attributes:
- A financial goal must have a monetary amount. Saying “I want to retire with a good income” is of little use. Instead, you need to specify the amount of income, or specify what you intend your lifestyle look like, so that the income you require is calculable. An example of such a goal would be “I want to retire with an after-tax income of $60,000 per year.”
- A financial goal must have a timeline. “I want to retire early” is too vague of a goal to work with; you need to set a time frame by using a specific age.
Taken together, your complete goal might sound something like “I want to retire by age 55 with an after tax income of $60,000” or “I want to pay off my $200,000 mortgage by age 45.”
As was said early, risk is more than how it is measured. Risk differs in each scenario, and with each added variable. Wealth management must meet goals, and risk is that it will fail to meet these goals.
Risk cannot be universally defined. What is risky to you based on your situation and goals, might be exactly what Bob down the street needs in order to have any chance of meeting his goals.
Example:
There are two twin brothers, Bob and Jim. Each lived very different lifestyle, Bob was always a prudent saver, whereas, Jim lived a frivolous lifestyle spending every dollar he earned.
Bob and Jim are now 55 years old. Both want to retire in 10 years at age 65 with $500,000.
Bob being the prudent saver, has $450,000 saved up already. Obtaining the remaining $50,000 should be easy. Jim, on the other hand only has $50,000.
Although they are the same age and have the same retirement goals, it would be unwise for their wealth management professional to treat them alike.
For Bob since he has almost attained his goal his portfolio will probably look less “risky”. The goal for Bob is to protect his assets and achieve a modest return.
Jim, however, doesn’t have enough time to take it slow. In order to have a chance of obtaining his goal, his portfolio will look a lot “riskier”, and he will have to contribute way more principal.
If we take this example and combine it with our earlier definition of risk, it makes sense. The chances of Jim achieving his goals with low “risk” investments is practically 0. However, using higher “risk” investments at least gives him a chance of obtaining his goals.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.
Concepts and ideas were taken from CSI text “Wealth Management Essentials V1”.
