Hazards Before Risks
Often as not, when starting to write this column, I have this overwhelming feeling that I have written this before. Then I settle in when I admit that I have, but in a different time, with different context and in a different manner. This is due to my fervent belief (some would say obsession) with the damage caused by high fees; ignored or unevaluated risks; a focus on money not people; and most of all, advice without responsibility to the client first.
Today’s column is about Risk. It is fascinating to me that Risk can be so hard to comprehend and appreciate and thus be so easy to ignore. So let’s see if we can find a way to feel the risk present by looking at it from a different angle.
First, let’s trot out that old adage in investing straight from Investopedia. “Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of a value in comparison to its historical average.” And, “Risk takes on many forms but is broadly categorized as the chance an outcome or investment’s actual gain will differ from the expected outcome or return.” Whew!
In other words, the more your investment moved up and down in the past, the less predictable its outcome becomes in the future. So if you take on risk, you increase the possibility of being 1) poorer, scared or angry or 2) richer, feeling safe and happy. We all want 2). How do I use this information?
Unusual to me, is that in investing we never discuss what leads investors to be put at risk. In other industries or situation, risk is rarely discussed without reference to “hazards.” See, a hazard is something that can cause harm, e.g. unpasteurized milk, bare wires, working under a raised vehicle, buying stocks, stress, etc. A risk is the chance, high or low, that any hazard will actually cause somebody harm. No hazard, no risk. If the milk is pasteurized, the wires are undamaged, you work on the car from above, etc., no risk, so maybe we should be evaluating investment hazards not investment risk.
So what are some of the hazards in investing that you can expose yourself to? You can buy penny stocks of companies that rarely survive. You can buy distressed bonds of companies in default or bankruptcy, you can buy …you get the point. You probably would not expose yourself to these types of hazards or the resultant risk. You may however increase your equity holdings as markets perform well; you may hold nothing but GICs because inflation is currently low; you may ignore the hazard of the high fees embedded in your investments; or you may fail to evaluate what action you will take after the market falls 35%. See, we all do a poor job of assessing that we have put ourselves in danger. We must try. You may find it easier to identify and avoid or reduce a hazard, than expending effort in assessing the probability of a risk’s occurrence.
Most importantly, it is easier to conclude that you were in a hazardous situation even if the outcome was not bad. When looking only at risk, the non-occurrence of a bad outcome will often leave the impression that there was no risk. If you cross a busy highway many times without being struck, you could conclude that it is not a risky act. However, when examining the hazard of entering the fast roadway it is hard to conclude that you are not putting yourself in harm’s way, every time. Not getting struck becomes an act of good fortune.
Step 1: Identify hazards, i.e. anything that may cause harm.
Some common ones are: Investing more aggressively than your emotions are surely able to support in a market fall; ignoring fees; not planning for withdrawals from a portfolio; not diversifying asset classes and regions; avoiding help from a planner or advisor when you lack interest or time to do it yourself; mistake sales promotion as advice. Sure, often none of these things harmed you in the past but the wire was still sitting there bare.
Step 2: Decide who may be harmed, and how.
Think about the effect of the hazard: on you; on your family; on your ability to spend or give; on your stress.
Step 3: Assess the risks and take action.
You must consider how likely it is that each hazard could cause harm. This will determine whether or not you should reduce the level of risk. Even after all precautions have been taken, some risk usually remains. You must decide for each remaining hazard whether the risk remains high, medium or low.
Step 4: Make a record of the findings.
Write it down. Later you can see that the hazards were accepted or avoided, irrespective of the outcome.
Step 5: Review the risk assessment.
Now that you can identify the hazards first, and know that you can choose to accept or reject them, the risk will be more evident.