Calculating Risk is a vital part of financial and investment planning. We need to weigh potential rewards against possible risks. We would all love to receive double digit rewards with no risk of losing money. Unfortunately, such an investment does not exist. It would be great if we could save the exact amount of money needed to pay for our retirement. In reality, however, we are going to save more than we actually need or we will run out of money. The idea of dying exactly when our last cent is spent is not a reasonable goal.
Lately I have been noticing how the concept of risk and reward appears elsewhere. We are mentally performing risk v. reward analyses continuously, in nearly all aspects of our lives.
Calculating Risk and Reward in Travel
I recently took a vacation that involved flying cross country with my unvaccinated child. My partner and I planned the vacation this past spring. It was a trip was to visit family, including grandparents, who we have not seen in over three years. In deciding to make the trip we examined many different factors.
- We were vaccinated but knew it was unlikely their would be a vaccine for younger children available before the vacation.
- We are all healthy and the hospitalization and death rates for children are relatively low.
- We settled upon an August date because we anticipated the risk level would be lower in the summer, after many adults had been vaccinated and before the school year and flu season began.
- The risk level of contracting COVID on airplanes is reported to be relatively small, but the contact risk in airports is much higher.
- We were only planning to see immediate family, all of whom were vaccinated (if eligible) and had also been attempting to limit their own risk of exposure.
- We would not dine out or do any indoor activities while traveling.
We thought through each aspect carefully and tried to do everything in our power to manage the risk. We determined that the reward of seeing family was worth the risk, within the perimeters outlined above, of contracting the virus.
Then the Delta Variant arrived. We had to reevaluate our entire plan.
We had contemplated the possibility of a surge. But, we had not considered a strain of the virus that children were more susceptible to. We needed to recalculate the risk of traveling. We also had to weigh the increased risk of the Delta Variant against the reward. Not knowing when the pandemic will end we considered how long we were willing to wait to travel. Could we wait another year or two before seeing family?
Ultimately, we decided to take the trip. We felt we were able to manage the risks of travel enough to deem it worth the reward. We were able to see all of our relatives and returned home without anyone becoming ill. We were fortunate in the results. We took precautions to reduce our risks while traveling such as vaccinating the adults, flying direct, not eating out and double masking. But these safeguards could not guarantee that we would not get ill.
Calculating Risk and Reward in Investing
My vacation considerations above are very similar to those risk v. reward calculations we must make when considering our finances.
Investing in securities always involves the risk of loss. When investing in securities such as stocks, exchange traded funds (ETFs), and mutual fund there is the possibility of the loss of principle. In layman’s terms, this means that you may get back less than your original investment.
As an investor, you must decide how much risk you are willing to take. There is generally a correlation between the risk you are willing to take and the return you may potentially earn. For example, if you invest in a money market fund you less likely to lose your principle investment. It is rare that a money market fund “breaks the buck”, or drops in value. In exchange for this relative safety, you are also unlikely to see high returns. Money market funds pay income that generally will not outpace inflation.
Stocks, however, have higher “volatility.”This means that the price of stocks and stock funds will have much greater fluctuation. The result may be earning a greater return, or it may be losing more money. There is a greater risk and the potential for a greater reward.
Multiple Types of Risk
When choosing investments it is not just a matter of predicting which securities will increase in value. There are so many more considerations. We do not just calculate the risk that a specific investment will drop in price (market risk). Important factors to consider when investing include:
- The investor’s time horizon
- The investor’s risk tolerance
- The investor’s risk capacity
- The diversification of the investor’s portfolio
- The risk required by the investor to achieve their goals
This means that the risk of investing in a specific security or type of security is not the same for everyone. There is a very personalized aspect to selecting investments. We must calculate the risk differently for each individual investor.
A person with a longer time horizon may make a riskier investment decision because they know they can afford to wait out any drop in price. Someone with a shorter time horizon may decide against the same investment because they do not want to risk needing to pull out their money at a time when the price is low. Likewise, the other considerations listed above are different for each investor at each point in time and must be contemplated accordingly.
The Individualized Nature of Risk and Reward
In the above story about travel, my partner and I were at risk of contracting COVID, but the greatest risk was to our unvaccinated child. My sister’s family made the same trip. In determining if they should travel, my sister’s family had many of the same considerations, but some different issues to examine.
For example, they are a family of five, with two adults and three teenagers. This means that their entire family was vaccinated. That reduced their risk. On the other hand, with a family of three we have the advantage of an entire group of three seats to ourselves. With a family of five, they were required to split up with someone sitting next to a stranger. That may make their flight feel more risky.
Similarly, we may have viewed the reward of the trip differently. We may have placed different priority on seeing family, the relationships may be different, they may have seen family more (or less) recently. Though making the same exact trip, my sister’s family had different risk considerations and different potential rewards. Ultimately, we all decided to make the trip. But, these differences could have led to us making decisions that were rational and considered but resulted in different choices.
Calculating Risk and Reward in Financial Planning
Within the area of finance, the concept of managing risk is certainly not limited to investing. Whenever we make a purchase we are comparing the reward of having the item or service to the risk of not having the money for a future want or need.
The entire insurance industry is built upon the calculation or risk v. reward. Most of us have some form of insurance – life insurance, homeowners, auto, etc. Purchasing insurance is a common way that we manage risk.
Let’s look at disability insurance. We all live with the risk that we could get injured or ill and be unable to work. Purchasing disability insurance can reduce the financial impact of injury or illness. If, however, we do not get sick or hurt then we are spending money on an insurance policy and receiving no monetary benefit. We each need to decide how the risk of getting injured compares to the risk of spending money on an unused policy. Similarly we must decide how the reward of potentially reducing financial impact compares to the reward of spending that money elsewhere. Again, each person has different considerations including their ability to self insure, their financial obligations, the piece of mind granted by having insurance, and so forth.
This is why financial planners often refer to insurance as “risk management.” We are calculating the risk of a specific situation and assessing how the risk can be mitigated.
Calculating Risk and Reward in Life
Risk/Reward analyses pertain to nearly every plan we make. It is certainly not limited to the financial realm. Above I gave the example of how I evaluated the risk and reward involved in family travel during a pandemic. But, there are much smaller plans that we make each day in which we calculate the risk v. the potential reward.
When you are deciding what to eat, you evaluate both the reward of the flavor and the risk of how the food may make you feel. You may crave pasta for lunch, but decide it is not worth the risk of wanting an afternoon nap when you have work to do.
Before bed you may want to watch another episode of your show or read another chapter of your book. You then compare that to the time and decide if the reward of enjoying the show or book is worth the risk that you will be tired the next day.
Life is full of risks and abundant in rewards. We are continuously making decisions as to which risks are too big to take and which rewards are too big to pass up. Managing your finances requires this same personal analysis. The factors and terminology may be less familiar, but the process is one that we all practice on a daily basis. We will never be able to avoid all risk and we will never get everything that we want. The key is to make informed, deliberate choices to reduce the risk and maximize the reward.