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Building a Healthy Relationship with Investment Risk

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

Whether it's saber rattling from North Korea, a possible U.S.-China trade war, or uncertainty about taxes and health care policy emanating from Washington, there is plenty of risk to go around in our world.

Yet investing probably isn't any riskier now than it was before. We are constantly reminding clients that while risk can't be eliminated, it can be recognized and managed. Understanding your relationship with risk is critical to developing and maintaining your investment strategy.

A little anxiety about risk is just human nature; how you deal with risk can make you a better or worse investor. Some reactions to risk seem to be universal:

One: We Underestimate Risk.
Imagining how risk will impact us is one thing; dealing with actual risk is quite another. Underestimating investment risk can trick you into believing that you can tolerate far more of it than you actually can. As financial columnist Chuck Jaffe has observed: "[A] common mindset is 'I can accept risks; I just don't want to lose any money.'"

We can't have it both ways. If you give into fear by panicking and selling, you'll probably lock in losses. If you manage to hold firm despite your doubts, you may be okay, but you may also have shouldered more emotional distress than you need to in pursuit of your financial goals.

Two: We Overestimate Risk.
On the other side of the pendulum, we also see investors overestimating risk and uncertainty. We humans tend to be loss-averse (as first described by Nobel Laureate Daniel Kahneman and his colleague Amos Tversky), which means we'll exaggerate and go out of our way to avoid financial risk – even when it means sacrificing potential rewards.

For example, world events can have a real impact on your personal and financial well-being. But the markets tend to price in unfolding news far more quickly than you can profitably trade on the information. It's a common investing pitfall to overestimate how this form of risk will impact your portfolio.

Three: We Misunderstand Risk.
When our fight-or-flight instincts kick in, it may seem important to react to current financial challenges by taking prompt action.

But once you've built a globally diversified, carefully allocated portfolio that reflects your personal goals and risk tolerances, it's usually prudent to discount both good and bad news that is unfolding in real time. There are two, broadly different kinds of risks that investors face.

Avoidable Concentrated Risks – Concentrated risks are the ones that wreak targeted havoc on particular stocks, bonds or sectors. In the science of investing, concentrated risks are considered avoidable. Diversifying limits their impact. If some of your holdings are affected by a concentrated risk, you can offset the damage done with other, unaffected holdings.

Unavoidable Market Risks – Market risks arise from investing in capital markets in any way, shape or form. If you stuff your cash under a mattress, it will still be there the next time you visit it, even if its spending power has eroded. Invest in the market and you're exposed to market-wide risk that cannot be "diversified away."

Four: We Mistreat Risk.
It's a delicate balance: You may underestimate the impact of avoidable, concentrated risks, or you may overestimate unavoidable market risks. Either miscalculation can cause you to panic and sell out or sit out of the market, thus missing out on its long-term growth.

In contrast, those who stay invested when market risks are on the rise are better positioned to be compensated for their loyalty with higher expected returns.

In many ways, managing your investments is about managing the risks involved. Properly employed, investment risk can be a powerful ally in your quest to build personal wealth. Be too risk-averse, and risk can become an equally powerful force against you. Friend or foe, don't be surprised when it routinely challenges your investment resolve.

Respect and manage return-generating market risks. Avoid responding to toxic, concentrated risks. These are the steps toward a healthy relationship with financial risks and rewards. Call us to discuss how we can assist you with achieving the best balance between risk and reward.