Clients often come to us with questions about risk; how much is too much? What’s the right amount for my portfolio? Is it better to err toward the conservative or the risky?
It’s not hard to understand why these questions come up – after all, without risk, there could be no reward. The key lies in finding that “sweet spot,” or the balance between aggressive and conservative investing strategies.
As such, we often tell our clients that accepting the inevitability of risk is one of the keys to being a realistic investor – and since risk cannot be avoided, the solution lies in managing risk for financial benefit. Here’s why successful wealth advisors embrace risk.
Your Comprehensive Financial Plan: Keep it Real
Using risk as a tool allows wealth advisors to work with, rather than against, reality. No one – not even the most successful advisor – can predict the future with accuracy, a fact that leads to an inseparable correlation between the future and risk.
Information, however, offers a way to reduce the degree of uncertainty that lies in the future. Consider the weather forecast: This confluence of physics, meteorology and analysis of current conditions and historical trends allows us to reduce uncertainty regarding tomorrow’s weather. The same general principles apply in the world of finance – but to a lesser degree.
Wealth Planning: Two Sides of the Same Coin
You’ve likely heard someone say, “You can never be too careful.” This advice may sound nice and apply to situations like crossing the street without looking both ways first, but it’s absolutely false when it comes to investing strategies.
There’s a cost associated with a too-conservative, too-careful portfolio, especially when that caution reaches past the point of efficiency. Consider that we all know that speed kills – but that doesn’t mean we should all drive 20 miles per hour. The key lies in finding the optimal balance between caution and danger.
As political scientist Aaron Wildavsky puts it, “Risking and living are inseparable.” In Wildavsky’s “jogger’s dilemma,” you can go jogging to improve your health and get hit by a car, but in general, jogging improves health and increases life expectancy. Safety is the other side of risk – and you can’t have one without the other.
It’s easy to apply this dilemma to the market, an economy that offers the potential for rich reward and, therefore incentives for risk-taking.
Quantifying Risk in Financial Strategies
The concept of probability offers a way to quantify uncertainty. While no wealth advisor can foresee the future, we can use knowledge and statistical analysis to determine which outcomes are more likely.
Quantifying financial data and trends allows financial advisors to derive probabilities in order to:
Estimate the strength of relationships – such as the value of exercising in maintaining health or the value of risk in obtaining financial reward
Evaluate the costs and benefits on a menu of choices
Make better predictions
In this way, risk can be utilized as a tool to aid in effective decision-making. Though it might not be as accurate as that local weather forecast on the nightly news, the process of quantifying risk allows an investment firm to reduce that degree of uncertainty.
And reducing uncertainty, even by a bit, is valuable in and of itself. After all, worry is one of the greatest obstacles to peace of mind -- and less worry about risk can only be a good thing.