Most people understand that life is full of uncertainties. We protect our families with life insurance and our cars and homes with auto and home-owner’s policies. But how do we protect our financial futures?
For some, the answer is avoiding financial risk; stay out of the stock market (remember the global recession?). For others, the answer is nervously trading in and out of the market based on the financial news of the day.
Both responses are symptoms of risk aversion. Unfortunately, risk aversion, itself, can carry risk – and lots of it.
The Risk of Risk Aversion
That’s right, the risk of being too conservative is real, even if it is a bit hard to understand. It can be nearly impossible to adequately grow your assets to a level that will cover your retirement needs – much less your wants – if you avoid risks, such as investing in the financial markets.
Yes, the financial markets can be risky. But those who avoid the financial markets or trade out at the slightest indication of trouble may be missing a big opportunity to adequately build their net worth.
Why? Simply put: growth potential. The financial markets offer opportunity and, rather ironically, they typically offer the most opportunity after a prolonged period of bad news – in other words, at the exact time when most of the risk averse have run for the hills. When the stock market falls, it’s natural to want to protect your assets. There’s just one problem. If the stock market has already taken a dive, it’s mostly too late to act. Unfortunately, many investors, particularly risk-averse investors, make many of their investment decisions based on past events. It’s not easy to avoid this quandary because the past is so easy to see and the future is one big question mark.
While it’s difficult to foresee the future, and past performance is not a guarantee of future performance, there is a simple way you can address risk aversion. It’s learning more about risk—all types of risk—so you gain perspective.
There are many investment-related risks, including individual risks associated with your specific circumstances and environmental risks associated with general events. Here are some examples:
- Personal risk: Job loss, illness and other life events are examples of risks that are different for each person and can change unexpectedly at any time.
- Market risk: How much will the price of your investments move up or down with general market trends? The great recession in the United States (2007-2009) and the ensuing global recession are extreme examples of downward market risk.
- Timing risk: How much will the price of your investment move up or down after you have invested? This risk can be particularly acute for Nervous Nellies who jump in and out of the market at the slightest whiff of trouble.
- Interest-rate risk: Changes in interest rates can create fluctuations in the value of investments, particularly bonds.
- Inflation risk: If you invest too conservatively, your returns might not keep up with inflation, which means your nest egg’s value can erode over time.
- Geopolitical risk: All types of world events, such as war, political upheaval and unfavorable economic policies create additional investment risks.
Risk is everywhere and investments are often susceptible to it.
What You Can Do About Risk Aversion
Stop focusing on specific risks. Instead, build an investment portfolio that fits both your risk personality and your future financial goals. A financial professional can help you find the proper balance between risk and reward. Then, as a team, you can determine your optimal investment plan based on your financial objectives and your tolerance for risk.
As a bonus, when you team up with a financial advisor, you have someone to turn to when you have second thoughts, such as when you are tempted to chase the next random payoff, or when you just want to hide your assets under your mattress.
Amin Dabit, CFP®
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