Over the last few years I have written a number of posts about risk mitigation and avoidance. This fits well with much of my philosophy in life. But today, I’m going to throw caution to the wind and go the other way. Today we are going to talk about the benefits of risk taking.
My Risk Taking Bends Conservative
As noted at the start here, I tend to think on the conservative risk mitigation side. You can see this in my writing, from posts about which to mitigate to articles about specific types. But just because I tend to be conservative does not mean I ignore the value of taking risks.
Investments and Risk Premium
After all, the fundamental aspects of any investment are essentially its inflation, earnings, and risk premium. So if you want a higher return on an investment, you generally have to take more risk. There is no clearer way to boost your return, which is why we so often push risky investments in things like stocks versus guaranteed bonds.
Risk Taking Implies More than Investments
Risk is bigger then investments. One of my happiest memories involves a calculated risk. I’ve mentioned it somewhat before in a post on our wedding expenditures. For our honeymoon we hiked the Kalalau trail in Kauai. For those who have ever read or done the trail you know where this is headed. The trail goes along sheer cliff faces with sliding gravel as it’s base for a large portion of it’s 11 mile trek. It’s not considered one of the most dangerous hikes in the world for no reason. It also happens to be one of the most beautiful. To this day my wife in one breath swears she will never hike it again. In the second she swears it was one of the coolest things we’ve ever done together. Besides, I love the look of horror on people’s faces when I tell people I camped overnight in a tent on my honeymoon.
Job Change is Risk Taking
Even job changes involve risk and typically have an associated premium. Why do you think the best way to earn more is to jump between companies? Because if they didn’t compensate you for such a move people would never do it. Being the last person in to a company represents a much larger risk to your employment then being a well respected member of your existing company. But if you want the big bucks you have to move on at some point.
So we can establish that taking risk is a must if you want to get ahead. The key of course is to take smart risks. While I hiked the Kalalau trail, I didn’t do something stupid like try to hike it with small kids or on a single day. When I invest I mitigate my investments with diversification, even if I still lean more heavily towards risky stocks. Before changing companies for a job I do my diligence on the companies future prospects before making a move. Mitigation of risk is a fundamental key to success, with each decision requiring you to put a mitigation plan in place based on the probability of occurrence.
Risk Mitigation Can Be Costly
So obviously I am not nuts, I’m not going to take on any risk I can’t at least mitigate in some way. But honestly mitigation can be costly. Take my trail example one more time. For a hefty fee you could pay someone to take you by boat to the deserted beach at the end. It would mitigate way more of the risk, but you’d miss out on the sense of accomplishment and the views along the way. Or you could do some light mitigation, like telling people where you are and packing the right gear. The level of mitigation you require is mostly a function of your risk tolerance (there is that word again).
Whether it be investments, job changes, retirement, or even hiking. The amount of risk taking and how much mitigation you require all depends on your risk tolerance. It is really important that you understand that tolerance to better make the correct decisions. Unfortunately the only way to truly understand your tolerance is to experience the risk you want to avoid. I got lucky here. Early in my career I experienced investment crashes, unemployment, and layoffs with the dotcom crash. I learned my risk tolerance early and it certainly has helped me along the way.
For those who have not experienced a crash the best I can recommend is to utilize a simulation. Ask a friend to tell you the stock market up and downs from day to day for a 2 month period. Instruct them to tell you the market will be down a significant amount on a random day. Now don’t look yourself at your portfolio or the market for the entire period. For the significant down days if you freak out and look to validate if it is a fictional day or reality you are not at the correct risk tolerance. This is not full proof, so ultimately you can’t be sure how much of your confidence will remain when your net worth drops by 50% overnight. I strongly suggest younger investors error on the side of caution.
Once you know your risk tolerance and how much mitigation you require all that remains is to determine if the decision is worth it. Simply put is there a return on investment that covers your risk. We talked about a framework for determine investment return here. The only piece that remains is to calculate the cost of mitigation and the risk itself. We gave you the cost of the risk itself in my uncertainty piece, ie. the probability multiplied by the impact. To this we add the cost of the risk mitigation and plug into the ROI calculation.
Then compare the ROI computation with any other choices. The one with the highest ROI is likely the one to do. Sounds simple enough, and as an individual you probably self consciously do this for decisions every day. The key is to apply that same logic more formally to your investment and career decisions. The thing is, I suspect many people out there do not. Based on personal observation I see a lot of poor risk based decision making amongst friends and family. They take too little risk in some spots, for example staying at the same company indefinitely. And in others they might take too much risk, like being 100% stocks or worse, investing a large chunk of funds in Bitcoin or gold. The key is to apply a consistent mindset to both risks based on your actual tolerance.
Take the Most Risk You Can Bear for the Best Results
Once you find that consistent risk tolerance level the key is to take smart risks. Not all risks apply a great return. The aforementioned Bitcoin as a large portion of your portfolio comes to mind. But if you find a smart risk then the final step is to the maximum risk of that type you can bear.
Take my comment about 100% stocks for a minute. Now let’s ignore for a moment liquidity. The reality is in almost every scenario over the long run 100% stocks has come out ahead of 80% stocks. Simply put the risk premium of stocks is higher than bonds, so they should return more than a portfolio with some bonds. After all why would anyone buy stocks otherwise? Alas few of us can ever hope to have risk tolerance to handle 100% stocks. If you could, and liquidity was not a concern, then mathematically the best option is to be 100% stocks. Instead there is a low cost of mitigation in investing 20% of your portfolio in low risk assets. So that is what we recommend most people do, allocate some portion of their portfolio to safe investments. It’s better to be down a little return, then it is to lose your cool during a crisis thus losing everything.
So do you agree about the value of risk? Do you know your risk tolerance?