Regardless of the stage of our financial journey, we are always bound to encounter risk. Knowing how to manage ongoing risk in your lifestyle and investments essential for living a balanced and healthy life.
Risk can be found in everything. The activities and investments we choose can be risky. And it can also be risky to choose not to invest in or do certain things.
On top of that, the risk associated with certain actions or investments can change over time. Risk is an ever-changing phenomenon which we must always be aware of.
Therefore, we need to take a constant, active approach to managing risk in our lives.
Welcome to the Investing Series – my thoughts on how we can use investments to minimise risk across every area of our lives.
Revisiting Risk
In order to learn how to manage ongoing risk, we first need to understand what risk is. I’ve written about risk earlier in the Investing Series, but I’ll summarize the definition here.
Risk is the chance of something bad happening. Whether it’s an investment failing, or the chance of injury when doing something strenuous, you can find risk in anything.
We take on risks in order to receive rewards. This approach guides us towards doing things that are ultimately better for us in the long run. Typically, we invest our money and time into things in the hopes that they provide a return, financial or otherwise.
It stands to reason that risk isn’t static either. An investment that starts out as a risky bet doesn’t necessarily stay that way after several years. Conversely, investments that were once seen as relatively safe may become high-risk assets. Other factors, such as the investor’s age, the current economic climate, and geopolitical relationships, can all drastically influence risk.
The risk-reward spectrum for everything we do is constantly changing. Knowing how to manage ongoing risk is a skill we must train and a muscle we must build. To remain efficient in our lives and finances, we need to ensure that the actions we take are optimised for risk versus reward.
Types of Risk
Risk can take on many forms. When managing your investment portfolio you need to be aware of how it can manifest.
Below are a few ways that risk can present itself and influence your investing decisions.
Individual Investments
Certain investments can often be seen as high risk, for example, stocks or shares. The idea of investing your money and tying it to the performance of a single specific company can be considered risky.
There are many people who wouldn’t consider investing in the stock market because they consider it to be akin to gambling. Of course, this is a surface-level argument, but there is a degree of truth to it.
Investing in an individual stock links the performance of your portfolio directly to the performance of a single company. If that company fails, your entire investment will fail. Having a portfolio concentrated heavily in a single asset class or group of assets within the same class or industry can have devastating consequences in a downturn.
Learning how to manage this ongoing risk is fairly simple. Avoid investing too heavily into a single asset class or industry, unless you are prepared for the losses. If failure of that asset or company would result in your portfolio’s value being ruined beyond repair, I would consider it too risky an investment.
There’s nothing wrong with investing in a single asset class if you believe it will perform, or if it has deep meaning for you. But you do have to be aware of the potential of failure, and what that will do to your investment portfolio.
Accumulation vs Preservation
Another large risk we have to contend with is how we balance accumulating wealth versus preserving our current wealth. While the stock market has produced a high rate of return over the long term, this is only achieved by averaging the rates of return over 100 years.
Unfortunately, most of us don’t have 100 years to build and accumulate wealth.
There’s a good chance that investing our money into a single asset class may not provide the return we need. Even if history states that it did in the past.
It doesn’t matter if that asset class has high long-term returns if we don’t have the time horizon necessary to weather the downturns. Therefore, we need to find ways to not only grow our wealth, but also to preserve it.
I know what you might be thinking.
“If investing is supposed to make me richer, why are you talking about losing money despite investing?”
It’s because investing is never a guarantee of reward.
Building a Post-Retirement Income
It goes without saying that we can invest over a long time horizon to accumulate wealth. However, unless we also understand how to apply risk correctly, we risk our hard work being undone at the end of the time horizon.
As we move closer to retirement, day by day, we need to ensure that we have an income source that meets our needs. Due to this, our relationship with risk changes. The focus of our investments shifts from the accumulation of wealth to preserving an income source.
How you choose to create that income source is up to you. Ideally, you can create a portfolio that both provides for your needs while also appreciating in value. This ensures that, should your needs increase in the future, you are still in a position to meet those needs.
The information outlined in my Saving Series should allow you to both reduce your expenses and increase your savings to the point where this is possible.
Entropy and Inflation
Entropy and inflation are two topics that I’ve written about in detail. The basic idea is that your life and your finances are both doomed to become more unstable over time, unless you put effort into maintaining them.
Inflation is the larger of the two risks in relation to financial investments. A scenario where your wealth is not accumulating at a rate faster than inflation is a catastrophic risk.
In this situation, even if the number of dollars you have rises, increased costs mean that the purchasing power of your dollars goes down.
We invest to triumph over entropy and inflation. The purpose of investing is to ensure that your future has the least amount of preventable chaos within it.
Knowing how to manage the ongoing risk of inflation is simple, but not easy. We need to ensure that the return on our investments is higher than the loss of purchasing power due to inflation. As a result, this means knowing which types of investments are likely to appreciate when compared to inflation.
Certain methods of investing your money, such as paper cash or money in the bank, will almost never appreciate faster than inflation. This is by design. Our money must be deployed in a manner that involves some risk to triumph over inflation.
Future Planning
Another major risk we need to learn to manage is how to plan for the unknown. Our health, relationships, families, and living situation can change drastically over time.
It’s difficult to think about how our lives will change in the future. This isn’t necessarily because it’s painful to think about those things1 — it’s often because we don’t know.
Many of us don’t put the effort into intentionally designing what our lives will look like in the future. On top of that, there are many things outside of our control that can derail any plans we make.
Think about your current situation in terms of finances, relationships, and living arrangements. You likely understand what those things will look like a month from now.
But how about six months? A year? A decade?
Our ability to plan this far into the future and account for every foreseeable scenario is impossible.
The further out you go, the less you know about what your life will look like. Written another way, it becomes more likely that you know nothing about your future life.
So, how do we adequately prepare for a future that we can’t begin to fathom?
You Can’t.
The way I see it, you can’t really plan for this risk. Things will happen that are out of your control, and you may not be in a position to deal with them.
Of course, you could take the extreme route and save everything you have to protect yourself against a future that may never happen. Alternatively, you could spend all of your money, only to find yourself facing never-ending misfortune.
Not planning at all easily leads to a life of misfortune and misery arising from not having enough. But the risk of over-preparing means creating a safety net that you may never utilise to its fullest.
Knowing how much to improve your circumstances now versus save for your future is an age-old question. It’s not a question I can answer it for you.
Like many things in life, the answer lies somewhere in the grey, boring middle. And where exactly it lies in that boring grey is different for everyone.
Closing
Knowing how to manage ongoing risk is an essential part of not only investing but living. We find risk everywhere in our lives, especially in managing our finances.
Below is a summary of the major things I consider when managing my own investment portfolio:
- Be aware of single points of failure in your portfolio.
- Ensure that your portfolio is either accumulating wealth or preserving it in line with your age, time horizon, and investment goals.
- Create a portfolio that consistently beats inflation.
- Be prepared for changes in your circumstances that result in requiring a larger amount of money to remain independent.
This isn’t an exhaustive list; there may be other risk factors that I haven’t considered that apply to you.
As with any investing process, the decisions made are always unique to the individual. Not only are those goals unique, but they are constantly changing as new information becomes available. As such, the risk level of your portfolio is also constantly changing.
If you know how to manage ongoing risk within your own portfolio, you are much more likely to be successful in your investing goals.
Thank you for reading.
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- Although this is often true. ↩︎