Risk is defined as a situation involving exposure to danger, harm, or loss. You experience risk and deal with it every day in many ways. You get in your car or truck and put on a seatbelt. You go to a pharmacy and buy toothpaste and mouthwash. You wear safety googles or glasses in your workshop. You use a hot pad or glove to take something out of the oven. You apply sunscreen before you go to the beach. You make repairs around your house or call a plumber or electrician. Those are all ways to offset risk. You don’t even think about risk until something out of the ordinary happens, and then it becomes important. For example, we all experienced risk in a dramatic way with the onset of COVID-19. No matter what risks are part of your life, every person’s threshold for risk is different.
Ways to Deal with Risk
The first way we deal with risk is to accept it. That is also called risk retention. Some risks are not big enough or are within our comfort zone, so we do nothing about them. If you work with power tools, or mow the lawn, or bake bread, or sew a dress, there are risks involved. When you go skiing or snowmobiling or tube down the river, there are potential risks. The danger is usually acceptable, however, if you are careful and follow basic safety rules. If weather forecast says there is a chance that you will be snowed in, you probably shop for extra groceries just in case. You accept the risk and probably don’t even think about it.
Another way to deal with risk is to avoid it. If you do not like the risk involved with sky diving or riding a roller coaster, you can choose not to do those things The same with driving through flooded streets, or eating unfamiliar food, or rock climbing. Risks are involved in meeting new people or going on vacation to a place you have never been before. Some people like those risks and accept them, others avoid them. Not many of us would agree to ride a bull or drive a racecar—we avoid it— but there are others who make their living doing just that.
We share risk in many ways. When we pay taxes, for example, we share the burden with many others so that we receive police and fire protection, postal service, clean water, and schools for our children. Your employer may share the risk of employees being away from work because of illness by paying a portion of health insurance premiums.
When you put on a seatbelt, get a flu shot, or install a home security system, you reduce risk. You are doing what you can and what is acceptable to you to mitigate the risk, and then you purchase insurance coverage to cover a catastrophic event.
Insurance is risk transfer. The amount and kinds of insurance you need depends on your age, your family, and your financial situation. If you are single and young with few assets, your need for life insurance, if any, is certainly less than a family with one breadwinner. Someone whose occupation is vulnerable to a lawsuit, such as a doctor, may transfer part of the risk via professional liability insurance. If you live in an apartment, personal property insurance is appropriate but not homeowner insurance. If your family has a history of medical problems, you may want an extra level of health insurance over what your workplace may offer.
The world of finance is no different. Risk refers to the degree of uncertainty or potential loss from a financial decision. All financial products carry some degree of risk. In general, as investment risk rises, you expect higher returns to compensate for that risk. For example, investors in stock generally expect a higher return than from bonds. There are more risks. What determines the level of risk, and therefore the expected return of investments? Differences include how readily you can get your money when you need it, how fast your money will grow, and how safe your money will be from potential loss.
Financial products for saving typically carry less risk than either stock or bonds and therefore you can expect a lower return on your investment. Money market accounts, saving accounts, and certificates of deposit are examples of saving products. They are typically used as temporary parking places for funds. You can get to money in savings products relatively easy, and they are therefore considered liquid. Savings vehicles are usually protected by insurance in the unlikely event that the entity—bank, credit union, or thrift institution—can’t pay you back. That also reduces the risk. (See my blog Happy New Year 2022!)
The upside to stock investments can be almost limitless, but there can also be dramatic downturns, as witnessed in 1987, 2000–2001, and 2007–2008. Stocks are typically more volatile than bonds. However, because there is more risk, there is also greater potential for return. Although the price of bonds fluctuates, the degree of fluctuation, or volatility, is usually less than stock, and therefore bonds are considered less risky. There is more certainty with bonds than with stocks. Bonds are a loan to the issuer, and in most cases, you can expect to receive regular interest payments and the return of your principal at the bond’s maturity.
Within each of the categories mentioned above there are subsets, and risks vary with each subset. For example, stock issued by a large U.S. company carries different risks than the stock of a small U.S. company or a company located in India. Likewise with bonds issued by those companies.
How to Offset Financial Risk
If you accept the fact that for your money to grow, you need to accept some risk; the best way to offset at least part of the risk is to own different types of saving and investing products. That is called diversification. The amount of risk that will be comfortable for you is not likely to be the same for others. When I was married, my husband and I had different feelings about risk but we both were good savers. We came to an agreement, a compromise, on what we would do with the money we set aside for the future. We bought a house and then sold that one and built another, we purchased CDs, stocks, and bonds. Each of us started putting aside funds for retirement via our company retirement plans which were invested primarily in mutual funds that contained stocks and bonds.
When we divorced and each took their share of assets, our risk preferences became evident. When it came to financial assets, he was more of a risk taker than me, and we invested our individual assets according to our respective comfort level. I am comfortable with a reasonable level of growth with a well-diversified portfolio of stock and bonds in the form of mutual funds and exchange-traded funds. I know that I will not reap the benefit of growth that a riskier portfolio might achieve. That is ok with me. I am comfortable, I can sleep at night, and I know that I will have enough, no matter what the markets do, to sustain my lifestyle for as long as I live. What is better than that? I want the same for you.
If you want some help to decide what level of risk is right for you, check out my blog, The Key to Investing – Know Yourself. Future blogs will take a deeper dive into saving and investing products—their differences, what drives their price changes, and the risks associated with each. Keep watch and keep reading, and please spread the word!
You might want to catch up on my previous blogs which are always available on bevbowers.com.
Until next week, happy reading!
Bev Bowers, CFP®
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Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark and the CERTIFIED FINANCIAL PLANNER™ certification mark in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.