We all take risks. Why? Because the rewards are fun.
But, do you truly understand the relationship between those two concepts? There is a versus going on beneath the surface: risk versus reward.
We find ourselves willing to take the risk if the reward is considered worthy.
In my own, not-so-recent past, I took the risk of being told, “No,” by the cute girl at the office when I asked her out on a date. I reap the reward of being married to her now for almost 17 years. Yes, Shannon and I met while working at an advertising and public relations agency. We didn’t work together but only a few months. It seems funny that it took another 18 years before we would work together again.
Frequently, we get asked what it’s like to work with your spouse. We’ve even coached other financial advisor spouses on how to make it work. Luckily, it works well for us and it’s very mutually encouraging. We challenge each other to get better. Do better. Level up! Yes, there are times that I just have no more words left that day, so I give her the 10-minute warning. As in, “I have 10 minutes of listening time left. Go!” She usually laughs.
Shannon relayed an entertaining story to me about a week ago. This husband and wife worked together for many years and are now retired. One day at work this wife was furious at her husband—she can’t remember why now. They had driven to work together, so at the end of the day, she just went home. Her husband calls her and says, “Where did you go?”
“Alright. Are you going to come back and get me?”
He walked the four miles home.
I hope I never make Shannon that mad. We live 10 miles from home.
Here lies a risk versus reward situation. The risk of working with your wife day-to-day and possibly making her mad enough to leave you stranded versus the reward of building a business together.
So, to apply this to money, how does the often-tumultuous relationship between risk and reward affect us?
When you invest money, there is a tradeoff between risk and reward.
The more risk you are willing to tolerate, the more reward you should expect—over time. It should grow more. The emotional reward revolves around winning. The emotional risk is watching your balance dip.
The less risk you are willing to tolerate, the less reward you should expect—over time. It will, more than likely, grow less. The emotional reward here is that your invested money should remain more stable.
An example is investing in an S&P 500 indexed mutual fund versus a Certificate of Deposit (CD) at the bank. The CD will pay you a specific interest rate and offer you the safety of FDIC insurance (U.S. government backed insurance) should the bank have trouble with its financial health—which is a nice sort of guarantee. However, the tradeoff is the money won’t grow very much. It might not even keep up with the cost of inflation.
That S&P 500 fund, on the other hand, should grow quite a bit over time if the U.S. stock market performs like it historically has. Now insert the standard financial disclosure, while using your best radio announcer voice, and say, “Past results should not be used to predict future performance.”
The trouble with the S&P 500 fund that scares most investors is the bumpy ride at times. An interesting fact is that an S&P 500 fund is certainly not the riskiest thing for people to invest in. For instance, holding individual stocks is much riskier.
I’ve found, in my years of experience, that people like winning.
When the market is going up, investors typically don’t focus on how much risk they’re taking. They like the roller coaster that only goes up.
However, when the markets are volatile, they focus intently on how much risk they’re taking. Because a volatile roller coaster that goes up, then down, then corkscrews upside down can create emotional exhaustion.
We’re humans. This is normal.
Investors like to win and will turn a blind eye to risk when they see their investments going up in value.
So, what is an investor to do?
Quantify your acceptable level of risk. Ensure your chosen investment portfolio (collection of money invested in different things) is in alignment with how you feel about risk.
Okay. Great. But how?
The Risk Number.
There are several FinTech (financial technology) companies that use this concept. The purpose is to remove all the subjective factors in a discussion about risk and simply quantify (using some pretty complicated math behind the scenes) what your acceptable level of risk is. Then, the software can analyze your current collection of investments and suggest how to build a collection that aligns with your acceptable level of risk. Basically, advising on what is appropriate for you emotionally.
The software I currently use is called Riskalyze. It uses the graphic of a speed limit sign to represent your Risk Number. The range is 1–99.
To get your Risk Number, you complete a short online questionnaire. The info is below if you want to try it out.
In addition, it can also produce a Risk Number for your investment portfolio.
Say your Risk Number is 50 and your portfolio is a 75. You might need to pump the brakes a little. This process revealed that your portfolio is riskier than your comfort level. If you tend to panic a little when you look at your account statement and see that your investments have declined in value, this might be an indicator.
Alternatively, if your Risk Number is 75 and your portfolio is a 50, that reflects investments that are a little more conservative than your comfort level. You may find yourself disappointed with the performance at times.
Is this a perfect system? No.
As a firm, we have been using Riskalyze on a limited basis over the last 6 months. What we have found is that the concept of the Risk Number has led to some insightful conversations. It has given our clients and us a common language when we discuss risk versus reward—and how that fits into a client’s overall financial plan.
When we can find common ground on the acceptable level of risk someone is willing to take, then it gives us the ability to guide our clients to make decisions based on what they value most. It assists in removing emotion from the decision-making process. Emotions make bad decisions. They can make you strand your husband at work. But maybe, that will clue in said husband to apologize—profusely. And get a ride home. Or not.
Understanding the connection between your acceptable level of risk and the level of risk associated with the stuff you invest money in, is the key. This risk key creates a more complete understanding of yourself and is paramount to understanding your investments. Awareness is priceless. Walking home from work might not be.
* The questionnaire takes most people about 5 minutes to complete. We will not use the answers or your email address for any reason other than to help you understand how you feel about risk. You will not get added to an email list automatically. We like to send emails to people who want to get them. When it asks how much money you have invested, make up a number or estimate. This is so it can give you dollar-choice-questions instead of just percentages. We will get a copy of your results and will happily send those to you by email, whether you’re a current client or not. This will immediately show your risk number. To chat more about what it means for you, please request an appointment. We enjoy these conversations.
* Cover photo by Jake Melara on Unsplash