“Risk-Averse Financial Planning: The Meek Shall Inherit Stability” is a post by Adina J, TimelessFinance columnist and author of Blue collar / Red lipstick.
Today, I am going to attempt to tackle a difficult topic that strikes close to home for me: how to incorporate risk into your long-term financial planning when you are risk-averse. It’s difficult because, well, I know I’m risking having all you investment whiz kids out there roll your eyes at me. Oh, the irony! Maybe I like a little risk, after all.
Still, by nature, I am the opposite of a risk-taker. I know – and hate – that there are no guarantees in life, but I want the next best thing. I want an almost sure thing, hold the “almost”. As you might imagine, my inherent aversion to risk has seriously hampered my financial strategy in the past. Risk is a crucial element of long-term financial planning, whether it’s at the active-income stage or the passive-income stage (which might be one and the same for some people). My risk-averse nature is one reason (among many) why I will never be a full-time entrepreneur. Because that isn’t something I am interested in changing, I realized it was all the more imperative that I become able and willing to countenance some degree of risk on the other side of the equation: investment.
I’ve had money in and out, and in and then, finally, out again of mutual funds since the age of 21. When I first started, I picked mutual funds as my investment vehicle of choice because, well, I didn’t know any better. Literally. My parents were fantastic about teaching me how to save, but not so much about how to invest – mostly because their lessons were taught by example, not by discussion; I knew my parents had money in the bank, I just never knew what they did with it. However, I had heard generic references to mutual funds in the media, so I figured that mutual funds were the answer.
A decade later, I figured out my mistake. My point here, though, is that I’ve been invested “in the market”, so to speak, for a comparatively long time for someone in her early 30s. (If you were not already convinced of the futility of mutual funds, let me pause here to add that, over that time, I barely broke even. Obviously, my mutual funds fell into that 50% that never ended up beating the market, despite the much-vaunted prescience of their managing analysts.) Yet, until very recently, I was never able to muster much courage to really “take on the market”. My mutual fund picks were always firmly on the conservative side of the spectrum, which meant that I rarely saw the upside of booms, and which translated into negligible returns. I never won big, and I never lost big; basically, between inflation and MERs, my investment died a slow, protracted death by a thousand paper cuts. (Credit for this phrase goes to Garth Turner who certainly has an ear for the pithy sound-bite and who, as Joe says, deserves the Order of Canada.)
And that, in essence, is the fate of the risk-averse in the financial sphere. You’re just sort of … there. Whatever market conditions favour the risk-averse – and I am not sure there are any – they did not materialize at any point in the last decade. With my twenties firmly behind me, I am no longer willing to take the risk – ha! – of waiting for them to possibly materialize at some point in the next 30 years. That said, it can certainly be an uphill battle for the rational mind to overcome one’s instinctive prejudices. When your gut instinct is screaming “Stash that money in a mattress!!”, how do you go about convincing yourself that the right thing to do is giving your money to a diagnosed bipolar, Mr. Market?
I wish I could tell you that I had an epiphany one day, after which I single-handedly developed a diverse portfolio of acronym-ed investments that has me beating the market with one hand behind my back. That didn’t happen. What did happen is that I finally staunched the paper cuts, and switched my family’s medium- and long-term savings into index funds. The other thing that happened was that I diversified across four different index funds – each with different exposures and levels of risk. My strategy, and motivating ideology if you will, was inspired by a book I’ve previously mentioned in passing, The Black Swan. In it, Nassim Nicholas Taleb sets out the “black swan theory” and explains why people are generally very inept at predicting the, well, unpredictable – outlier events that are game-changers, whether good or bad. Our general approach to predicting future events is heavily reliant on the past, which – as every turkey would tell you the day after Thanksgiving, if it wasn’t deceased (and a turkey) – is not nearly as accurate an approach as we like to think. If windfalls are to be made on the market, they are often made by people willing to bet on the seemingly improbable. Like the people who bet against U.S. mortgage-backed securities before 2006. Of course, to a risk-averse individual like me, that sounds frightening. So, then, how exactly did The Black Swan motivate me to embrace risk (a little bit more)?
What ultimately really resonated with me was Taleb’s approach to investing. He writes that his preferred means of dealing with uncertainty and possible black swans is to determine a threshold for his risk tolerance; in other words, how much he is willing to lose in a worst case scenario. He takes that amount and invests it in the riskiest ways possible, keeping everything else in relatively safer investments (but not in his mattress, presumably). As simple as it sounds, this approach was an eye-opener for me; it got me to think about ways that, short of picking individual stocks, I could tailor a personalized portfolio of investments without professional expert help. I had always thought about mutual (or index) funds as an all-in proposition, but I finally started to ask myself why that had to be the case. The idea of allocating varying amounts to funds with differing risk quotients – according to my formula, not the bank’s – was very appealing. The bank’s categories of investors, which are used to identify the “best” funds for each individual according to their supposed “type”, are about as accurate in addressing individual circumstances, needs and idiosyncracies of personality as I am in hitting the bullseye at darts, in the dark, after a tequila bender (Editor Joe’s Note: I, too, end up in this exact situation all the time). And, moreover, so what if, based on the bank’s dozen ever-so-insightful questions, I am considered a conservative investor? The point (which no bank rep has ever taken the time to explain, I might add) is that I SHOULDN’T be one at this point in my life … not if I don’t want to spend my retirement bumming change off my kid.
Bank-directed diatribe aside (don’t they always feel so satisfying?), the point is that reading a book about the unpredictability of life- (and market-) changing events, paradoxically, helped me to break free from my risk-averse, drone mentality. Strangely enough, once I embraced the concept of a high-risk component in my portfolio (10% in my case), I actually found myself more willing to up the risk quotient in the remainder of my investments, whilst feeling more comfortable than before with my overall exposure; perhaps, it felt all ”safer” by comparison – psychology is a funny thing. The breakdown of my portfolio now looks something like this: 10% higher risk index funds, 40% medium-risk (spread across two index funds focused on different markets), and 50% relatively “safe” investments (Canadian bond index fund-type stuff). I am curious to see how this strategy will pan out over the next while, as compared to my husband’s more traditional, bank-approved approach (as it turns out, I am actually not the most risk-averse person I know).
Considering the general financial acumen of TF’s readership, I expect that many of you will have plenty of constructive (or just plain) criticism for me, which may come in handy next time I need to tweak my portfolio. But I am especially curious to hear from other fellow risk-avoiders: how do you accept risk, and in what measure, as part of your investment strategy?