Updated: Jan 12, 2022
Risk and fear are one and the same. If you are completely risk-adverse, you are very fearful. And, if you are completely risk-prone, you are fearless. These two situations are at the far ends of the risk spectrum. Being extreme in one regard or the other with risk will likely get you nowhere, and even in a lot of trouble, unless you are extremely lucky! Understanding risk, and if, how, and when to use it, will help a lot on your journey as a DIY investor. In reality, you may want to adopt different risk levels based on your own personal sitiuation and the accounts you are working with, but you do not want risk to overwhelm and paralyze you.
When I was still with a Financial Institution and an Advisor managing my money, my risk profile was assessed annually. I filled out this questionaire that asked me questions about my expected investment time horizon, my overall knowledge of financial products, the returns I expected, amongst other leading questions which spit out a risk profile. From this I fell into one of a few investor categories including aggressive, moderate, or conservative, or somewhere in between. Over time I would start to associate risk with knowledge and confidence, and nothing else. I would see that as I learned more my sense of risk would diminish, and I became confident I could handle my own finances with much, much lower costs. People’s perception of risk is their own reality, and that reality can be changed by you if you increase your confidence.
These Financial Institutions have to do these risk profiles as a form of CYA (cover your ass), in order to put some sense of control back in your hands over how your money is invested. You are pidgeon-holed into a category (risk profile) that paves the way for an Advisor to select their products that fit your risk profile. In many ways, these surveys simply reinforce a personal view of your own knowledge and confidence. The whole process and the questions used instill fear in your abilities. You start to think “I am what I am”, I need help, this cannot be changed, or I can't be bothered. In reality, it can all be changed.
One way to look at the overall risk aspects of investing is to picture yourself looking over a cliff. You are very high up and it is a really long way down! Of course, this can be very scary and can paralyze you towards making any movements! You paralysis becomes your inactivity to do anything to change your situation. You may be very old and feel you cannot take much of a fall, without fear of damaging yourself beyond repair. You may be very young and feel invincible, like you can fall twice as far and just get back up and dust yourself off. Age will change your fear and risk level in life. You may not trust your balance, especially as you get closer and closer to the edge. The fear of falling is just too great, so you back away, taking a safer position based on your overall confidence. The proximity to the edge of the cliff can easily be associated with your own sense of financial risk, and the fall can be easily related to the stock markets. What would make you more comfortable on the edge of the cliff in this case? After all, you have this overwhelming fear that this fall is really going to hurt or even kill you, and you have all these emotions in play telling you this is a really bad idea. Well, maybe a barrier or restraint like a fence or being tethered off? The fence is a barrier to your emotions, and the restraints represent confidence in your knowledge and skills. But what if the tether breaks and you go crashing through the fence and take the fall? Then what? It can happen, despite all your knowledge and control of your fear, for example, a stock market crash! What would make you more comfortable should you have to take a fall? In this case, you will want a safety net at the bottom to catch you. That safety net is your portfolio construct. Bonds will slow and cushion the fall, while stocks will accelerate and extend the fall. Together they offset each other to a degree, resulting in a shorter fall and a softer landing. The above comparison is a relatively simplistic way to associate your investment fear with real life fear, and the things that will make you more comfortable managing your own risk. What if you took a few shots of Tequila? You are likely to make extremely poor choices on Tequila! This could really cloud your judgement, making you climb up on that fence, perhaps not secure that tether properly, or jump off the cliff with no safety net? The Tequila of the financial world is equivalent to confusing financial media coverage and FOMO (fear of missing out) on new things like crypto and reddit meme stocks, and it is a real challenge to stop drinking Tequila these days. Seems like many are becoming alcoholics in this regard.
So you get ahold of all this fear, educate yourself, and establish that maybe you can take on (a lot) more risk, should you? This is where it gets a little interesting because risk is a different animal when applied in different places and over different time horizons. For instance, should you take on excessive risk in your RRSPs? Arguably not, as these financial vehicles are the ones that you will contribute to for 25-35 years, and the ones that provide you with stable, reliable income in your retirement years. These are accounts that are best suited to slow and steady growth and returns, during both your accumulation stage and especially in the decumulation stage. These are accounts you will need to draw on every month or every year to provide your income throughout retirement, and keeping them from bouncing around too much is probably a good strategy. In retirement, if you are going to take on a bit more risk, you should place risk in places where you don‘t need the money right away, or can let it ride in the markets for a year or two if things get choppy, which they will. You should set limits on what you are investing in based on assuming this higher risk, because betting the farm on Gamestop or Bitcoin is likely to put you in the poor-house, or at minimum with undue stress in your golden years? At any rate, assuming different levels of risk in different areas needs to be considered, and just because you can take on more risk doesn’t necessarily mean you should. Once you start understanding risk for what it really is, and removing it where you can to the extent it doesn’t cripple your game plan, everything gets easier. At the end of the day, your knowledge (confidence) about investing, your account goals, a balanced and diversified portfolio, and your ability to resist FOMO will help you combat and manage risk.