Written by: Travis Shelton, Executive Contributor
Executive Contributors at Brainz Magazine are handpicked and invited to contribute because of their knowledge and valuable insight within their area of expertise.
Risk is all around us. Every day, when we wake up and go about our business, we’re taking risks. When we hop in our car, we’re taking a risk. When we share a new idea with our boss or spend money on a new product, we’re taking a risk. Risk is everywhere!
For nearly 15 years as an institutional, commercial real estate investor, my job was to manage risk. Not eliminate risk, but manage it. Each time I invested in a new piece of real estate, whether it be a skyscraper, mall, or apartment complex, there was some level of risk. Risk is always present and our goal isn’t to eliminate it. If I wanted to eliminate all risk in my work, I could have simply stopped investing in real estate. But that’s what clients hired me to do: invest in something with risk, earn a healthy financial return, and manage the risk along the way.
Life is much the same way. Every day, we take risks. Let’s use the example of getting into our vehicle and driving to work. There’s a real measure of risk there. If our goal was zero risk, we would simply torch our vehicle and forever lock ourselves in our home. Sounds ridiculous, right? This is a perfect illustration of how we as humans aren’t actually seeking to remove risk but rather to manage it. We wear our seat belts, check our mirrors, drive at a reasonable speed, keep an eye on our blind spots, etc. Each of these measures acts to reduce risk, but none of these safety efforts fully eliminate it.
Risk is a topic I think about a lot. One thing has become clear: generally speaking, humans are very bad at assessing risk. Sometimes we grossly overestimate risk, while other times, we grossly underestimate risk. A big reason why we’re so bad at assessing risk is we tend to measure it with feelings. After all, fear is a powerful force! When we go down the route of using fear to manage risk, we’re already making poor decisions.
If fear is counter-productive in assessing risk, we need a new baseline.
There are two primary components to risk, each needing its own assessment. First, we need to assess the probability of the negative scenario happening. What are the odds something bad will happen? Depending on the subject matter, this can be tricky to estimate. The second component is just as tricky. In the event a negative scenario plays out, how severe will the consequences be?
I’ll use a recent real-life situation to play out these concepts. My family recently attended the wedding of a dear friend, and our five-year-old twin boys were the ring-bearers. As we’re in my wife’s car about to begin the 30-mile journey for the pre-ceremony pictures (which our kids need to be part of), I notice the fuel light flashing on our vehicle’s dashboard. Did it just turn on, or had it been on for days? My wife had no clue. Thus, we had a situation at hand. This is when the risk analysis portion of my brain kicked in. In my brain, I’m thinking we have a 90% chance of getting to the wedding venue barely on time, without incident. This would be a win. On the other hand, there’s probably a 10% chance we’d run out of fuel on the way. My wife, who is notoriously bad at assessing risk (please don’t tell her I said that), proclaimed we should keep going because we’ll “probably be fine.” She was right. We probably had a 90% chance of getting there without incident. However, she wasn’t thinking about the second component. If we hit the 10% scenario and ran out of fuel, it would easily cost us 90 minutes, and our twins would inevitably miss the pre-wedding pictures.
There are a few important numbers we can derive from this data. The first is the best-case scenario (on time), the second is the worst-case scenario (90 minutes late), and the third is the mathematical expected outcome (weighted average). The math is simple. We’ll take a weighted average of the various outcomes to determine the average result if this scenario were to play out countless times:
(90% chance x 0 minutes late) + (10% chance x 90 minutes late) = average outcome
(.9 x 0) + (.1 x 90) = 9 minutes late on average
9 minutes late. That’s not so bad! 9 minutes wouldn’t materially alter the outcome of the day. From a risk mitigation perspective, this feels like a pretty good bet. We’d have a 90% chance of getting there on time with an average expected outcome of 9 minutes late. This could all play out without issue and nobody would ever know!
However, there’s one more critical consideration we need to account for when assessing risk. The worst-case scenario needs to be strongly considered. One question to assess this is to ask ourselves if our life will be significantly hindered if the worst-case scenario happens. Let’s go back to the wedding example. If we’re 9 minutes late, it may result in a slight eye-roll from the bride, but no material harm will be done. There’s one problem with this approach, however. We don’t have dozens of repetitions here to rely on an average. We’re either going to be on time, or we’re going to absolutely ruin their pictures. It’s a one-time, binary proposition. A 90% chance for a non-event and a 10% chance for an absolute disaster.
As I was sitting in the driver’s seat assessing this risk, I had to make a decision. Knowing I couldn’t stomach the downside scenario, I elected to stop for fuel on the way, which shifted the probability to a 100% chance of being 5 minutes late. Not a perfect outcome (worse than the 90% probability outcome of being right on time), but it managed the risk and provided an acceptable outcome.
While we don’t face this exact scenario often (if ever), we do encounter dozens (or hundreds) of similar-but-different scenarios each day. For most of them, we’re likely to take the approach my wife takes, “it will probably be fine.” What does “probably be fine” mean, and what does the downside look like? Those questions are key!
One of the craziest questions I hear, in my opinion, is when financial advisors ask their clients what their risk tolerance is when it comes to investing in the stock market. Remember, we tend to measure risk with fear. If we don’t understand the stock market and how it works, it only compounds the perceived risk via our fear. For many of us, our context of investing in the stock market is anchored by all the people in our lives who are buying and selling individual stocks…who inevitably get crushed. Through this lens, yeah, the stock market seems very risky! But this is a feeling of fear rooted in poor decision-making from those around us.
We need to understand what risk really means in this context. It’s true that the stock market will likely face many wild swings. I’ll use the S&P 500 (index comprised of the 500 largest U.S. companies) and refer to it as “the stock market” in this article. Historically speaking, the U.S. stock market has experienced a 10% decline once every 19 months and a 20% decline once every 4 years. This FEELS risky! After all, nobody wants to invest their money and likely have it take a 10% hit within the first year-and-a-half. That feels brutal.
That’s where I’d like to dig into the definition of risk. Yes, the stock market is volatile. It always has been, always will be. But I propose volatility doesn’t equal risk. Volatility just equals volatility. In its simplest form, the definition of risk, according to Merriam-Webster, is “the possibility of loss.” Volatility isn’t a loss. For most of us, we aren’t investing for 1, 5, or even 10 years. We’re investing for the long term. Our children’s education, retirement, a second home down the road, or an inheritance to be passed to the next generation. In the U.S., we aren’t even allowed to access our investment retirement accounts (without taxes/penalties) until age 59.5. That means if someone reading this is 30 years old, you can’t even think about touching this money for another 30 years!!! And if that’s true, why should you care about the volatility that occurs between now and then?
Back to the definition of risk: the possibility of loss. Through the end of 2021, we’ve had 151 years of recorded U.S. stock market history dating all the way back to 1870. If we look at the year-by-year breakdown of how the U.S. stock market performed, we can start to get a sense of probabilities and severities (like the wedding example above). Here’s what history tells us:
Over a 5-year period of time, we have an 11% chance of losing money, with the worst outcome being we lost just over half our money (5 years ending in 1932…the great depression). That feels quite risky!
Over a 10-year period of time, we have a 2% chance of losing money, with the worst possible outcome being we lost 14% of our money (10 years ending in 2008…a period bookended by the tech bubble burst and 9/11 on front and the Great Financial Crisis on the back). That doesn’t feel too risky.
Here’s where it gets good. Over a 15-year period of time, we have a 0% chance of losing money, with the worst outcome being we gain 19% on our money (15 years ending in 1943). That doesn’t feel risky at all!!
I’ll give one more example. Over a 25-year period of time, we also have a 0% chance of losing money, with the worst outcome being we more than triple our money. That’s right, a 4.92% annual return, resulting in having about 3.3x as much money as we started. If you’re a 35-year-old who plans to start accessing their investments at age 60, historically speaking, you have a 0% chance of losing money and a worst-case scenario of more than tripling your initial investment. Wow!
Understanding risk matters. I’ve walked countless clients through these numbers and worked to shift their perspectives when it comes to risk. When we reframe our perspective about what risk is, how to assess it, and apply it to various aspects of our life (without fear), it changes everything!
What’s the risk of asking that person out?
What’s the risk of applying for that job?
What’s the risk of going the extra mile on a project, or in a relationship, or xyz?
When we can take the fear out and assess risk for what it is (or isn’t in many cases), it becomes so much easier to navigate this crazy journey of life, work, and money.
Travis Shelton, Executive Contributor Brainz Magazine
Travis Shelton is a financial coach, speaker, writer, and host of the Meaning Over Money podcast. Through various platforms, he engages in conversations about money and work, but through a different lens. He aims to help people live a life of meaning by pursuing work that matters, creating an impact on others, and redefining the role money plays in their lives. In his coaching, he works with people ranging from teachers, executives, missionaries, business owners, lawyers, doctors, and professional athletes.
