As planners who attempt to evaluate and manage numerous variables in our Member’s financial lives, the question of risk comes up often. To many novice investors, these questions are almost framed as if we, as retirement and financial experts, have some proprietary insight into the future, a crystal ball that has been honed by years of study and experience. Somehow, we must be able to predict the future.
In the case of more experienced investors, they tend to understand we cannot predict the future, but tend to expect minimal or no loss, again, due to our years of training and experience in this field. They expect that we will have a better intuition into the beginning of major market collapses and thus, once we see such dark clouds looming on the horizon, position ourselves to avoid the brunt of the storm.
The truth is far less exciting. In fact, as Certified Financial Planners™, we are constantly looking to protect our members and take advantage of opportunities that offer asymmetrical risk. Although this may sound like a big, sophisticated statisticians’ term, asymmetrical risk is really quite simple, it is the accepting of outsized returns for a small amount of risk. Or, in the case of risk protection, it is paying a very small price to protect against a major calamity.
In the case of investing, assume you found a casino game in which the bet was $10. The dealer flips a fair coin and if heads comes up, you lose your $10, however, if tails reveals itself, you are the winner of $30. How often would you play that game? As a CFP®, I would park myself in front of the dealer and tell my wife and kids I will see them next spring. Although I am not able to predict the next flip of the coin and I certainly cannot guarantee a win on any one attempt, I can promise that with enough games played, I win. In fact, the expected outcome over time is an average of a $5 profit per flip. This is a perfect example of asymmetrical risk. Of course, there is still risk I will lose my $10 on the first flip (maybe even $20, $30, $40, or more if I am very unlucky), but with enough patience, I’ll make a handsome return.
Asymmetrical risk is seen often in investing. When putting money to work in a diversified portfolio of stocks, bonds, real estate, and cash, there is certainly a chance that your return next month or next year will be negative (your first coin flip). It is the reason we tell people who only want to invest for a year or two to find a good CD or money market account to stash their cash. We do not want to risk the possibility of poor timing or bad luck that may spoil their plans. However, even long-term investors with poor luck will do fine with enough time and fortitude to withstand their poor luck.
A real-life example is during the financial crises of 2008-2009. If you invested $10,000 in the Dow Jones Industrial Average in the fall of 2007, you lost money for the next 18-months and in the spring of 2009, opened your account statement to find only about $5,000 remaining in your account (that is a long, unlucky streak of several heads in a row). However, the key was to keep playing. If you didn’t touch your money, continued to reinvest dividends, and rode out the rollercoaster, your account was valued at right around $20,000 in 2017. Despite your poor timing and bad luck, your investment doubled in 10 years. That is the type of asymmetrical risk we love.
A corollary to growing your assets is protecting them. Life insurance is a great example of asymmetric risk. For the relatively minor cost of a few hundred dollars a year, we can purchase a life insurance policy that will protect our loved ones from financial ruin if the unthinkable were to happen to us. We transfer this risk to the insurance company for such a small cost, we hardly notice the effect on our lifestyle.
As you plan out your financial future, particularly your retirement, think about how you can utilize asymmetrical risk to your advantage. There is certainly no guarantee that you will win each coin flip, however, with enough opportunities, you will put yourself in a very comfortable position to live your life on your terms. If this is not something you are comfortable managing yourself, give us a call, we are glad to help!