Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

Financial decisions ultimately boil down to two simultaneous considerations:

  1. How much risk is involved, and
  2. How much reward or return is expected

Doctors understand the interplay between risk and reward. There are often multiple treatment options for a given patient. Each choice is accompanied by some amount of risk and some potential gain in terms of improved health. The key is to form a judgment about which choice yields the superior tradeoff.

Decisions in any setting, be it medical, financial, political, etc., must consider both risk and return. This is a crucial observation. Sellers of financial products and services invariably try to get you to focus on one or the other. They try to tempt you using the “greed” motive by focusing on rewards or returns, or they try to scare you using the “fear” motive by focusing on risk. You must always insist on considering both together, in balanced fashion. The golden rule of financial decision-making is: always make decisions based on simultaneous and objective consideration of risk and return.

 

What is Risk?

Risk is present when we engage in activities that yield uncertain outcomes with potentially negative consequences.

Consider rolling a pair of dice or tossing a coin. You’re uncertain about which numbers between one and six the dice will settle on, or whether the coin will land on “heads” or “tails.” When at least one outcome has negative consequences, you face risk. For example, if you bet money on the dice roll or coin toss outcome, you are facing risk. On the other hand, if there’s no money at stake—that is, no downside—we would say the situation is uncertain, but not strictly speaking risky.

More generally, a negative outcome may arise in the form of financial loss, property destruction, physical injury, reputational damage, emotional setback, etc. We will focus on financial losses.[1]

Some risky scenarios such as the dice roll or coin toss may exhibit only a handful of distinct potential outcomes {1, 2, 3, 4, 5, 6} or {heads, tails}. When you invest in the stock market there are potentially many negative outcomes (theoretically an infinite number),  covering a wide range of potential gains and losses. When you start your own private practice, you face various risks, with a wide range of potential positive and negative earnings outcomes, including the extreme possibility of bankruptcy.

Investments expose us to what is known as Speculative Risk. According to Investopedia:

"Speculative risk is a category of risk that, when undertaken, results in an uncertain degree of gain or loss. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances."

In other words, we consciously choose to take on speculative risk, motivated by potential upside or financial gain. When we discuss insurance we’ll cover a different kind of risk known as pure risk.

 

Likelihood and Severity

Risk is often divided into two dimensions:

  1. The probability or likelihood of a negative outcome occurring, and
  2. The severity of damage or loss in the event a negative outcome occurs

For example, a bank considers lending money to a medical practice. The first dimension of risk the bank faces is the possibility that the borrowing practice will go bankrupt—this is the probability of the negative outcome. The second dimension is the amount of the loan that may be lost due to the bankruptcy—this is the severity of the negative outcome.

To mitigate the first dimension (the probability of default), the bank will closely examine the medical practice’s proposed business plan, its intended location, the experience and credibility of its management team, etc. To mitigate the second dimension (the size of the loss), the bank will demand collateral: including specific assets to secure the loan, such as real estate, equipment, inventory, etc. 


Risk Tolerance
As noted earlier, the golden rule of financial decision-making is: Always make decisions based on simultaneous and objective consideration of risk and return.

The golden rule leads to some fundamental questions: Can we be objective about risk? Do we all feel the same way about risk?

Not surprisingly, it turns out that we all have different attitudes toward risk. We may feel very differently about the same risk. Most of us are somewhat conservative and don’t like facing risk at all. We have a low appetite, or a low tolerance, for risk. Economists describe us as risk averse. That is, we exhibit a natural aversion to risk.

In contrast, a smaller percentage of the population falls under the category of gamblers or risk lovers. Risk lovers have a large capacity to tolerate risk or a big appetite for risk. These are the people who go bungee diving, jump out of planes, and generally tempt fate. Their reward for these daredevil activities is the adrenalin rush.

Because people have different attitudes toward risk—some of us are more averse to risk than others and some of us love risk to varying degrees—we don’t all react the same way to the same risky situation.

Let’s set up an experiment to distinguish people’s relative levels of risk aversion. Begin by arranging a scenario with a fixed level of risk, and then measuring how much reward, for example, how much money, must be offered to each person to get them to agree to take that risk. The most risk-averse among us will require the highest reward to accept the risk, whereas the risk lovers will accept the risk just for the thrill of it, with little to no financial reward. The reward each person demands in order to accept the risk can be called that person’s risk premium. We can sort our test subjects by risk premium, from highest to lowest, yielding a risk preference ranking. The people at the top of the list are the most risk averse, and hence require the highest risk premium to accept the risky deal. At the bottom of the list are the risk lovers.

Government regulators (and common sense) require brokers and financial advisors to understand each client’s risk tolerance. This is meant to ensure clients receive products that match their risk preferences.

A highly risk averse investor should end up with a very conservative (low risk) portfolio and only a person with low risk aversion (high tolerance for risk) should undertake very risky investments.

 

Measuring Risk Tolerance

In practice, brokers and investment account administrators use responses to questionnaires to measure our risk tolerance. Some of the questions seek to determine our investment horizon; how long we intend to maintain the investments before we need access to our money. Other questions seek to determine our attitude to risk-taking. Time horizon questions have more to do with our ability to accept risk than with our emotional willingness to accept it. Both ability and willingness to take risk are relevant in determining the risk profile for our portfolio.

The concept of risk aversion is perfectly sensible in theory: If we can measure risk tolerance we should do so. But the questionnaires used to assess risk tolerance are flawed. It’s not always easy for investors to answer the questions accurately. It’s not that they don’t want to. It’s because the wording of questions may bias the answers, or because investors aren’t sufficiently in tune with their feelings about risk to provide accurate answers.

In fact, investors are likely to answer the same questions differently depending on their state of mind, which may be highly influenced by external conditions. For example, an investor may feel extremely vulnerable immediately following a market crash, leading to conservative answers to the questionnaire (once bitten, twice shy). That same investor, six months earlier, during the giddiest moments of a spectacular bull market, may well exhibit overconfidence, giving answers consistent with a very high tolerance for risk.

Typical risk tolerance questions are similar to these[2]:

1. I must begin withdrawing money out of my investment in:

          A. Less than 3 years

          B. 3–5 years

          C. 6–10 years

          D. More than 10 years

 A client selecting (D) has a longer investment horizon and therefore greater ability to withstand the negative effects of market volatility compared to a client selecting (A).

2. Which would you prefer to invest in?

          A. Highly diversified portfolios

          B. Individual company stock

          C. single startup company

Here, the answer (A) suggests high risk aversion, while (C) suggests low aversion to risk.

Another potential question might be:

3. If the stock market declined by 20% tomorrow, would you:

          A. Sell all your stock investments?

          B. Sell half of your stock investments?

          C. Buy more stock?

In this example, a highly risk averse investor would be expected to choose (A), while a risk loving investor might choose (C).

On the surface, these questions appear to reveal risk aversion. But as already noted, our risk aversion is affected by circumstances. The upshot is that there’s a Catch-22. The only way we can accurately answer questions designed to reveal our risk tolerance is if we already know our risk tolerance. Many people don’t understand enough about the emotional context of decision making to answer these questions objectively. Unsophisticated financial advisors also don’t get it. For them providing the questionnaire is equivalent to checking a box for the purposes of compliance and legal liability coverage. They don’t understand, and may not care about, the limitations of the process from a risk tolerance identification perspective.

If you want to sleep well at night, you must carefully consider your comfort level with risk. Try to imagine how you (and your partner) would feel under various market downturns. Then ask yourself: Are my current circumstances, for example: investment choices and insurance coverage, consistent with my feelings about risk? Your evaluation of risk preferences must consider how you’ll feel when investments sour!

There are analogies to these concepts in other aspects of our lives. For example, we may enter our first romantic relationship without any regard to the potential downsides (very low risk aversion). But by the next relationship we’re likely to be more guarded—more reluctant to commit fully to what we know is an emotionally vulnerable scenario.

It’s easy to get caught up in discussions of negative outcomes. But most of us don’t take risks for the sake of risk. We take risks because we expect some reward or return.

 

Related Links:

Schwab Investor Profile Questionnaire

 

What is Financial Gain or Return?

Return refers to the upside, profit, or benefit we seek from participating in some activity. The return or reward may be physical, emotional, or financial. In our financial context the risky activity is investing, and the upside comes in the form of favorable investment returns.

Investment returns come in several forms:

  1. Income we receive on investments (dividends received on stocks, interest received on bonds, or rent payments on property we own), and
  2. Capital gains from selling assets (stocks, real estate, a medical practice) at prices that are higher than what we paid for them

Consistently generating positive returns on investments helps to steadily grow our pillars of wealth. 

When we initiate a risky investment we have some sense of the range of possible return outcomes. Our best guess of what the return will be is the expected return. Mathematically, the expected return is typically an average of the various potential return outcomes. Once the investment’s outcome has been determined, we know exactly what we’ve gained (or lost) and this quantity is known as the realized return. The realized return may be higher or lower than the expected return.

Investors dream of finding high expected return investments with low risk. While unscrupulous advisors may claim they can offer such deals, market realities make them highly unlikely. The low probability of such mythical opportunities gives rise to the cautionary expression: There’s no free lunch on Wall Street.

A fundamental tenet of finance is that the expected return of an investment must be commensurate with the risk undertaken.

Thus, we should only accept a very risky investment if there is a reasonable expectation that it will yield a very high return. It follows that we should expect a low return on a low-risk investment.

For example, high yield bonds, as the name implies, offer higher yields or expected returns than investment grade bonds. The former are issued by firms with low creditworthiness and hence higher risk while the latter are issued by firms with more stable prospects. Alternatively, stocks issued by very small firms are generally riskier than stocks issued by much larger and more established corporations. Investments in the former are expected to provide a higher return than investments in the latter.

Typically, we allocate our wealth to a range of investments, some of which offer higher returns at higher risk, and others offering lower returns at lower risk. Each person’s risk tolerance influences her decision regarding how much overall risk to take.


[1] Doctors face all these potential negative outcomes—not just financial ones. All are relevant when it comes to wellness.

[2] If you’d like to see more of these, simply search online for “risk tolerance questionnaire” and explore the search results.


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