Investing wisely starts with understanding how and why you handle risk
As physicians we face many different types of risk every day, from the risk that a patient will sue to the risk of the government changing laws, or even the risk that our relief won’t show up at the end of our night shift. Risk is also inherent in how we manage our finances. This month we’re going to discuss the definition of financial risk, how to minimize it and how to accept it. Because in the end, there’s no such thing as a risk-free environment.
A textbook definition of risk would read something like “a condition in which there is a possibility of an adverse deviation from a desired outcome.” More simply and mathematically, risk is the chance of loss multiplied by the magnitude of the loss. So it’s not enough that the chance of loss is low. If the impact of the loss is huge, then risk is high. We know that the chance of any given patient suing us is low, but since we stand to lose millions if we do get sued (high magnitude), we buy malpractice insurance. This same concept applies to other types of insurance, such as homeowners or auto insurance.
More fundamentally from a personal finance perspective, what you should really care about are two definitions of risk often overlooked by physicians: the risk of not meeting your future goals (such as retirement living expenses), and the ultimate risk of running out of money before you die.
Basically there are only a few ways to handle risk. First, you can avoid it. This principle should be applied to the risk which has both a high likelihood and magnitude of loss. For example, in your investment portfolio you should avoid unnecessary and unreliable risks, such as the risk of owning individual stocks and dramatically underperforming stock market averages. Not only is the chance of underperforming high but the consequences are enormous. This is a risk you shouldn’t be taking to begin with.
The second way to handle risk is to accept certain types of risk. For example, while you should avoid individual stocks since they do not carry a reliable reward, that does not mean that you don’t invest in stocks at all. Rather, you can still accept the risk of owning stocks by owning diversified mutual funds.
Finally, you can use insurance to transfer the risk – particularly a risk that is low chance but high magnitude – to a third party. The insurance mechanism works because lots of other people are doing the same thing and so you’re spreading out the risk across the pool of insureds. If you think about it, diversifying your investment portfolio across lots of different investments is really a form of portfolio insurance.
Since we have to take some risk in our investment portfolio to achieve returns, there are basically three ways to determine how much risk you have to accept. The first and most important is your need to take risk. What are your goals? How big are your goals? How many goals do you have? The greater the number of goals and the larger the goals, the more risk you need to take if you hope to meet them. The second is your ability to take risk. What is your age? How far away are your goals? What are your income and expenses? The third is your willingness to take risk. How affected are you by market declines? Will you buy more or sell more as the market drops?
Your willingness to take risk also applies to other parts of your financial life. What are your deductibles for your insurance policies? What are the limits to your insurance policies? When do your disability policies start paying out? Higher deductibles and lower limits mean you are willing to take more risk.
The cover of the June 2010 issue of Money magazine states “High Returns Low Risk” in big bright letters. If you believe that such an investment exists, then I assume you also believe in the tooth fairy and Santa Claus. Let me say this just once: There is no such thing as a risk-free investment, and there is no such thing as an investment with high returns and low risk. Think about it: why would any investment be priced in such a way to have high returns and low risk. One thought is that investments such as cash and CDs are no risk. That may be true only if you look at the risk of losing the principal value (CDs for example are FDIC insured). But what if the interest from cash investments does not support your current or future lifestyle? This gets to the idea of risk tradeoffs—when you eliminate one type of risk, you always take on another. For example you could stop driving a car altogether, but while you would eliminate the risk of a car accident you might be fired from your job for being late.
Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA