Risk In Personal Finance : The Desire Vs The Need
Taking on risk is an essential prerequisite for anyone who wishes to participate in the financial markets and/or manage their money. The degree of risk that each of us can digest is invariably dictated by the relationship between the amount of risk we are willing to take, and the amount of risk we are willing to take. This has become common knowledge.
But there is another aspect that we forget to take into consideration when assessing our behaviour with investment risk. That aspect being whether we actually need to take on a particular risk in light of our needs and financial situation. Yes, there are situations and conditions under which we may need to take on more open to taking on less or zero investment and financial risk even though we may have the desire to. There may also be situations where we need to take on more risk than we are willing to. And in today's post, I'm going to highlight situations where we would need to understand the balance between the desire to take risk against the need to take risk. This would help us understand whether we would be better served taking on an increased degree of risk, a reduced degree of risk, or maybe even none at all in light of the situations we face.
Let us begin by understanding the difference between the desire to take on risk and the need to take on risk. The desire to take on risk is born when we find an investment opportunity that offers a potential return which is significant enough to tempt us to take on the kind of risk that is associated with that opportunity. The need to take on risk shows whether or not taking on the kind of risk associated with an investment opportunity would make a meaningful and positive difference towards helping us achieve our financial goals. Therefore, while the desire to take on risk simply looks at the tradeoff between risk and return, the need to take on risk gains most of its relevance from a risk management perspective. It manages risk by showing us the kind of risks we can avoid taking in light of our respective financial situations.
Also, just because we have the desire to take on risk, it does not always mean that we need to. There are many situations in money management where would come across risks and investment opportunities which we would seemingly be able to take and digest easily, but we would actually be better served avoiding them completely because we don't really need to take on those risks. The first such situation may be faced by those who have achieved financial independence relatively early (say by age 45-48) and still have almost half their expected lifetimes in front of them (assuming a life expectancy of 80-90). In the case of such individuals, the ideal thing to do would be to park their money in a portfolio of traditional and market linked assets which generates a return that keeps pace with the rate of inflation applicable to their lifestyles. That is all they need. But, the fact that they have achieved financial independence may induce a false sense of security. This may lead them to think that they can now take on any degree of risk without having to worry about the adverse implications of their decisions. This sees them employ their money to trade extremely risky assets such as futures and options (collectively called derivatives) and cryptocurrencies. The problem with such assets is that the gains and losses generated by such assets are predominantly asymmetrical. So, any losses they suffer are likely to be exponentially greater than the amount of capital they put into such avenues. And this could be enough to wipe out a significant portion of their net worth, thereby putting their state of financial independence under threat. Moreover, such individuals may not have enough time to regain the money they lose to such events, especially if they occur in their later years like their sixties and seventies. And in light of their actual needs in life post financial independence, such risks are completely unnecessary. Therefore such drastic risks are best avoided, even when financial independence has been achieved.
Now take the case of someone in their early twenties just beginning their careers. In most cases, this is the stage of life where individuals shoulder the least amount of financial responsibilities and therefore have the greatest room for risk taking. And naturally individuals in and around this age group choose to handle their money with a lot more freedom than most others, tending to allocate a large portion of their investment portfolios to risky assets such as equities. Having a significant exposure to equity would definitely make sense for such individuals, given their age and lack of people who are financially dependent on them. But that being said, an excessive exposure to equity may not be warranted due to the risk of greater portfolio volatility and potential behavioural immaturity on the part of such individuals. Therefore, their desire to take on extreme amounts of risk is more likely to be slightly misplaced. They instead need to ensure that they manage the risk they take on by reducing their exposure to equity and diversifying their investments across a variety of asset classes in accordance with an asset allocation strategy and financial plan.
Those of us who have careers that pay us extremely well over extended periods of time may feel that money management and taking on investment risk may not be as important, because all our needs can be provided for by our earned income in itself. This sees them put most of their money in highly safe avenues such as bank deposits and other non market linked avenues. But when employing such a strategy, we also need to be aware of how long we can retain the potential to keep earning such handsome amounts. Take the case of a sports person or a movie star for example. Those employed in these professions undoubtedly earn handsomely so as long as they are working. But the key thing to consider here is that both these groups of individuals have a set period during which their earning potential is high, after which it may drop drastically. A sports person's earning potential peaks from their mid 20s until say their late 30s. The average film star would experience supernormal earnings over a period of 10-20 years beginning in their late teens or early 20s. But their money would have to last them for at least another 40-50 years over the rest of their expected lifetimes. And it is extremely rare and difficult for someone to be able to maintain their earning potential over such long periods of time. Therefore, those who earn more than enough to meet their needs at present must also look to take on a moderate degree of investment risk. This would ensure that their money would continue to keep pace with inflation and grow at stable rates even if the potential to earn income were to drop in the future.
A reasonable degree of risk is essential to be able to achieve any results worth noting from our investments. At the same time, it makes no sense to risk a lot or all of what we have to chase what we do not need. And this is something that we must always keep in mind when evaluating a certain form of financial or investment risk and deciding whether or not to take it on. Investment risk must only be taken on to the degree where our ability, willingness and desire to take on risk is matched by the need to take it. Risking too little could ultimately that we find ourselves short of money at the most critical time. Risking too much may mean that we leave ourselves having to face the unpleasant scenario of dealing with significant and mostly irreversible financial setbacks. Therefore we must find the perfect balance between all major aspects of investment risk in order to be able to make the most effective and rewarding financial decisions.