How to Think About Risk
"Some see risk as a reason not to try. Some see it as an obstacle to overcome. The risk is the same, to try or not depends on your perspective."
-Simon Sinek
I'm sound asleep when the annoying sound of the alarm clock starts blaring. It's 6:30 a.m., and I'm not used to getting up this early, even when I'm not on vacation in Las Vegas. It's even worse, though, because I just went to bed 5 hours ago, and my head hurts.
I was out too late with some people that I met on a recent rafting trip. I didn't mean to stay out this late, but the conversation (and wine) was flowing, and there are no clocks inside casinos.
This morning I have to try to catch a bus to get to Tropicana by 7 a.m. I'm going skydiving, and when I signed up for it, 7 a.m. seemed like a perfectly reasonable time.
I finally get to where I'm supposed to be and find that many other people are already here. I strike up a conversation with a person I’ll call Karl. Karl is from Costa Rica, and this is his first time in Las Vegas; we have that in common. Karl is also on a solo trip; another thing we have in common.
When we meet one of our guides, we are handed waivers to sign. As you can imagine, the waiver is quite long, given that this is for skydiving. I start going through the waiver, reading about all the ways that I can be injured or killed, initialing each page as I go through.
I look over at Karl and see him flipping through the pages as quickly as possible, scribbling on every page. Jokingly, I have some if he's going to read what he is signing.
He tells me, "no. I really want to skydive, they don't let you go unless you sign, and I don't want to know what it says because then I might not sign."
Definition of Risk
Everybody has heard of risk. But if I asked you, you might struggle to define it. Risk is effectively the idea that something bad can happen. In other words, when you go about your life, you have some expectation in your mind about how it will go. Our minds do a great job of helping us envision what might happen in the future.
When that vision of what might happen in the future turns out to be worse than we expected or worse than we hoped for, we call that risk.
For example, you might envision walking to your mailbox to get the mail, but you then slip on the ice. You might envision driving home from work but get in a collision. You might envision feeling good after going on a run but sprain your ankle. Or, you could envision getting a 7% return on your investments but only get 2%. These are all examples of risk; things not working out the way you hoped.
There are two dimensions of risk to consider; likelihood and consequence.
Likelihood of Risk
The first element of risk is how likely it is to show up. In other words, what's the probability that something bad will happen? If it's highly likely that something bad will happen, that's riskier. If it's highly unlikely that something bad will happen, we call that less risky.
For example, imagine standing on a cliff. If you are far away from the edge of that cliff, then it's a pretty low likelihood that you will fall off.
On the other hand, if you're standing right on the edge, it is far more likely that you will fall off.
Consequences of Risk
The second dimension of risk is the consequence of that risk. In other words, if you assume that the risk shows up (no matter what the probability was), what will happen? Sometimes it's not as bad as you think, but other times it's worse than you imagined. If the consequences are tolerable, then that would be considered less risky. If the consequences of the risk showing up are dangerous, that's riskier.
Let's use our cliff example again. If we assume that I fall off of the cliff, but it's only three feet high, then those are tolerable consequences, and I would consider that to be less risky.
But, if I fall off of the cliff and it's a hundred feet to the ground, then those are dangerous consequences and be considered riskier.
To put it another way, if I'm driving my car on a winding road, there's a risk that I will move out of my lane at some point. If that happens, it's no big deal, and I can just get back into my lane. If concrete barriers are used as the lane dividers on the exact same road, then even though the likelihood of me moving outside of my lane is the same, the consequences are higher, and I'm likely to drive slower.
Consider Both Sides of Risk
When you make life decisions, including financial decisions, it's important to consider both aspects of risk. You can think of these two aspects as being a grid. By viewing it this way, you can get an informed view of whether you should participate in this particular decision.
If the risk has a low probability of happening and the consequences are tolerable in the unlikely event that it does show up, then you'll probably be okay. You’ve done the work ahead of time to realize that this was technically possible, and if it does show up, you can view it as more of a setback.
On the other hand, if the risk is highly likely and the consequences are dangerous, then this is something you should not be partaking in.
The last two quadrants are the tricky ones. If the risk is highly likely, but the consequences are tolerable, then this is probably okay, especially if the upside is well worth taking the risk. However, it's important to be prepared for that.
There are times when the risk is very unlikely, but the consequences are very dangerous if it does show up. This is a scary place to be. This is why we have insurance. Now, insurance only covers the financial risk. If the risk you're considering is not financial in nature, then you have to pay more attention to this. That means that even if you are a very strong skier and even if the chance of an avalanche is low, there is still a chance that you could die.
Consider all aspects of risk.
Risk and Return Are Related
I am in no way advocating not taking any risk. In fact, we have to take risks. There will always be risk. Our job is to pick which risks we are willing and able to handle. Some risks are worth taking because there is a reward that we get for taking that risk. I might get in a car accident driving to dinner, but by taking on the risk of driving I'm rewarded by getting to enjoy dinner at a restaurant. Typically, the more risk you take, the more reward you should expect. In fact, you can flip this around and phrase this as the reward being your payment for taking on the risk.
In other words, you can't get rewarded if you don't take some kind of risk. Said another way, if you don't want to take any risk, you can't expect any kind of reward.
Life is not a matter of choosing to take risks or not. It's a matter of determining which risks we’re comfortable taking. We get to choose the risks, and subsequent rewards, that we can tolerate and that we find worth it. Understanding the risks that you face and how to manage them is not only possible; it’s healthy.
You only have one life. Live intentionally.
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Related Money Health® ReadingReferences and InfluencesWilliam Bernstein: The Four Pillars of Investing
Collaborative Fund Blog: The Three Sides of Risk
Roger Gibson, Christopher Sidoni: Asset Allocation
Carl Richards: The Behavior Gap
Note: Above is a list of references that I intentionally looked at while writing this post. It is not meant to be a definitive list of everything that influenced by thinking and writing. It's very likely that I left something out. If you notice something that you think I left out, please let me know; I will be happy to update the list.
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