Following on from my previous newsletter about risk and the gross misunderstanding and misrepresentation we are seeing these days in the news, I wanted to go further and talk a little about how we, at Permanent Wealth Partners, think about risk.

Now describing risk is a little like describing music. Very hard to do on a piece of paper, but much easier if you experience it. However, one benefit we have is that we all experience risk, we probably just don’t call it that or aren’t aware it’s happening to us.

In its most pared-down form, risk to us is two factors:

{The likelihood (probability) of a given outcome happening (either good or bad) within the time frame being assessed, and the impact (either good or bad) of the outcome.}

For example – the likelihood of getting hit by a bus in the next week is very low, but the severity is devastating. Or, the likelihood of our investments falling 40% in one year is actually relatively high over our lifetime, but how severe would that be? Like most things, it depends.

One of my favourite financial writers, Morgan Housel, has written a deeply moving and personal article on this exact topic

www.collaborativefund.com/blog/the-three-sides-of-risk

His point is around the consequences of not considering the tail-end of risk; the curve-balls, the once-in-a-blue-moon events that have the ability to completely throw us off course whilst seemingly “coming from nowhere”.

So if we look at the above risk definition from our experience and research, there are three possible actions we can take once those risks are identified: mitigate, insure or embrace.

I will discuss each of them in turn.

Mitigate

This is probably the hardest concept to get our heads around. To mitigate risk involves doing something to either reduce the likelihood of the bad outcome happening OR reduce the severity. Or both.

An example would be to have a safety net of cash – say one year’s expenditure – sitting on the sidelines as part of your financial plan.

Having this cash can mitigate a number of different risks.

Lose your job? Well, you have one year to find another one because your one year’s expenditure is already there in cash.

Markets drop 40%? Well, you have cash to potentially put into the market at that point to take advantage of this fall.

But it’s also not just cash. Something like keeping healthy – regular exercise and eating well mitigates somewhat the risk of illness and also makes you more productive at your job.

Insure

For certain risks which are at the devastating end of severity, then mitigation is not enough. For these risks, we can do little to reduce the likelihood as most will happen by chance. However, we can offset the severity by putting in place insurance that will pay out a financial sum if the outcome was to happen.

For example, a family would be devastated by the loss of a parent. However, having life cover that pays the mortgage out on death at least prevents them from being homeless.

Or taking time off to have treatment or recover from a serious illness can be devastating to your income, but not if you have an income protection policy in place.

Embrace

The final action we consider around risk is to embrace it.

Uncertainty is baked into both financial markets and life. One could even argue that trying to suppress uncertainty and make things ‘safe’ can have potentially disastrous consequences in its own right. So embracing some of that uncertainty and exposing the correct assets to it can lead to much better outcomes in the future.

For example, a pension pot that you most likely do not need (or are not allowed) to access for 20+ years should do much better if invested in a low-cost passive 100% equity tracker fund, than if it had bonds or property or other diversifying assets in there. Yes, it will be more volatile, but history tells us the overall return over a long period of time will be significantly higher. Which is more important do you think?

We think a lot about risk as it impacts all of our own and our clients’ lives.

The key message is that risk is not necessarily all bad – once we dig into it further with our clients and help them understand the consequences and how it applies to their own individual circumstances, we find our clients often feel liberated as a result.

If you would like to understand risk, in all its guises and how it applies to you, get in touch for a discussion.