Journal of Financial Planning; November 2014
The increasing interrelatedness and complexity of our world, plus the accelerating pace of change virtually everywhere are driving unsettling realities. It seems that instability, unpredictability, uncertainty, anxieties, and the risks they produce will intensify over time.
Successfully planning and investing in this rapidly changing, unpredictable environment places increasing importance on effective risk communications and risk management.
This article reviews how we can recognize and avoid some of the biggest unrecognized errors made in understanding and managing risk, while improving the quality of our risk communications with clients.
Mistake No. 1: Not Asking Clients What Concerns Them Most
When initially meeting with investors to learn their current situation, goals, and objectives or when conducting a regular review with existing clients, there’s an opportunity to gain important additional insights by asking them one simple question: “Which risks are you most concerned about?”
Instead of only using a generic, risk profile questionnaire that attempts to squeeze clients into one of a few risk categories, a great deal more information and insight can be gained by asking this question. Their response will quickly guide you to what’s most important to them. Asking this question also demonstrates to them that you are interested in and concerned about their personal risk priorities. Once you’ve heard, fully explored, and noted all their responses, you can discuss any additional risks that they should be concerned about. With that information you can then integrate strategies for addressing all those risks into your financial planning and risk management planning process, plus follow through by addressing them in your asset allocation recommendations and portfolio construction.
Because you’re already talking about risk, it’s an easy transition into a conversation about how clients personally define risk, and the importance of both you and them agreeing on a common, empowering definition of risk.
Mistake No. 2: Not Using an Agreed Upon Empowering Definition of Risk
Clear, open, and unambiguous communications between a planner and every client is critical to maximizing the effectiveness, value, and ultimate success of a planner’s advice. No single element of planner/client communications is more important than being certain that you, your clients, and potential clients are in complete agreement on your shared definition of risk.
This is important, because the term “risk” can carry many different meanings depending on how it is used. If not directly addressed early in your relationship, any mix-up in meanings can lead to serious miscommunication issues. It’s also important to be certain you’re focusing on the risks themselves, not the results of risks.
Here are a few examples of the multiple meanings of the word risk, as articulated by risk communications experts Paul Slovic and Elke U. Weber in their 2002 paper “Perceptions of Risk Posed by Extreme Events”:
Risk as a hazard. Which risks should we rank?
Risk as a probability. What’s the risk of getting AIDS from a contaminated needle?
Risk as a consequence. What is the risk of letting your parking meter expire?
Risk as a potential adversity or threat. How great is the risk of riding a motorcycle?
When it comes to risk, the basic definition you use is also the critical foundation on which your entire risk management approach is built. Our definitions of things are the frames through which we describe, understand, and view them. With a solid definition as your foundation, what you build will make the job of risk management for you and your clients easier and more effective. It will also serve you and your clients better, and stand the test of time. With a weak or inferior definition, even the grandest, most sophisticated risk management methodologies will be compromised, leading to frustration, disappointment, and negative surprises.
Many financial planners and investors use one or more of the following definitions of risk:
- Possibility of harm
- Market volatility
- Loss of capital
- Possibility of loss
- Below benchmark returns
- A potential threat
- Standard deviation
- Negative surprises
How do these definitions make you feel about your ability to deal with risk? Do they empower you, make your job easier, and give you and your risk management abilities a better sense of control? Or do they make you feel that you have little or no ability to manage such phenomena?
These definitions of risk may not empower us because they describe the results of risk(s) versus defining them. Volatility, loss, variations in returns, negative surprises, harm, and negative consequences don’t happen in a vacuum. Something causes them, so they become secondary, or in some cases, even tertiary results of actual risks manifesting themselves.
Medical students learn early in their professional training the critical importance of treating the underlying disease rather than the symptoms.
Financial planners need to learn to focus on the risks themselves, not the results of the risks. You must first identify the risks, then successfully avoid, prepare for, neutralize, or manage the risks so the results of those risks occurring are either prevented from occurring or dramatically reduced.
A truly empowering, practical definition of risk comes not from the investment world, but from Apple. Peter Oppenheimer, Apple’s chief financial officer, and one-time chief risk officer (who retired at the end of September) defines risk as “the degree to which an outcome varies from expectations.”
Consider this simple definition’s far-reaching implications:
- It’s an empowering definition, because although we have little or no control over the future, we alone have total control over the full range of our expectations of potential outcomes—both good and bad.
- The more realistic our range of expectations, the fewer surprises we’ll experience, the better risk/reward decisions we’ll make, and the better risk managers we’ll become.
- Our expectations of the possibilities is under our control, and that is not the case when we abdicate the control to totally random occurrences or statistics.
- It gives us the power to influence the fact that risks with the greatest negative impact are typically those risks that aren’t expected or we’re not normally prepared for.
- It helps us think through the full range of possibilities while recognizing that surprises happen all the time.
- We have the power to ignore, accept, and prepare for what we expect.
- It gives us the power to deal with negative and positive variations from expectations.
- When we know, understand, and are prepared for risks, the very nature of that understanding and preparation can neutralize risks that do occur, converting them from possible nightmares into minor inconveniences and even potential opportunities.
Mistake No. 3: Not Using a Proven Method for Neutralizing Risk
More than 150 years ago, Ralph Waldo Emerson articulated a key concept of effective risk management. He observed that, “Knowledge is the antidote to fear.” Because fear is integral to our natural risk management system, and a challenge all planners continually face, that insightful observation reinforces the notion that improving our and our clients’ knowledge of risk is key to reducing the fear of risk. It also helps clients minimize the self-inflicted damage caused by fear-based investment decision making.
Better knowledge about risk also opens the door to better risk management and becoming more comfortable and confident investors. Pair increased knowledge with deeper understanding and thorough preparation, then risks are managed much more effectively, and fears and anxieties are dramatically reduced.
Simply stated, and with very few exceptions: Risks that we’ve (1) identified, (2) thoroughly understand, and (3) are fully prepared for in advance, can be effectively neutralized and prevented from harming us.
This method offers a simple, step-by-step process we can use in helping clients manage virtually any risk, including the full range of investment risks.
Mistake No. 4: Lacking Awareness of the Characteristics of Risk
Because every risk is different for every individual, a critical element of an effective risk management approach is understanding the three characteristics of a risk:
Exposure/context. Will the individual and/or investment approach/investment vehicle/portfolio be exposed to a given risk, and if so, what level of exposure do they have? None, low, moderate, or full exposure? Direct exposure or indirect exposure? (We don’t need to be concerned with risks we’re not exposed to.)
Likelihood. What is the likelihood/probability of the risk occurring? High, moderate, low?
Impact. Should the risk occur, what impact (short-term and long-term) will it have on the individual and/or investment approach/investment vehicle/portfolio? None, low, moderate, or high?
Mistake No. 5: Not Helping Clients Determine Which Risks to Avoid and Accept
Financial planning practitioners and investors can unknowingly act against their own best interests by giving their highest risk management priorities to the likeliest risks. Although it seems logical to tackle the risks that show up so frequently, and it’s gratifying to swat down some of those nuisance risks (like volatility), it’s actually a trap. Dealing with frequent, low-impact risks can consume valuable risk management time and resources, leaving us even more vulnerable to infrequent—and more harmful—high-impact risks.
Placing a priority on addressing high-impact risks, even if they’re unlikely, can pay off big time. When those low-probability, high-impact risks come out of the blue and devastate those not prepared for them, being ready for them in advance can save much heartache, not to mention many dollars.
The most effective method of prioritizing risks is to focus on impact first and likelihood second. In descending order from the most important to the least important, here is an example of how various risk impact and risk likelihood combinations should be prioritized.
- high impact/high probability
- high impact/moderate probability
- high impact/low probability
- moderate impact/high probability
- moderate impact/moderate probability
- moderate impact/low probability
- low impact/high probability
- low impact/moderate probability
- low impact/low probability
This ranking system has proven its effectiveness in determining which risks to avoid, accept and manage, and accept outright across the full range of human endeavors from science, medicine, aviation, construction, and farming, all the way to firefighting, police work, childcare, film making, and sports.
Where this methodology really shines in the investment world is in how it can adapt to each client’s or each portfolio’s specific investment purposes and priorities.
Implementing These Methods in Your Practice
It may seem, initially, that implementing these methods will only lead to incremental gains in your risk management effectiveness, yet the exact opposite is true. Begin using this approach with clients, and you’ll see how effective it can be.
The process of embracing and using an empowering definition of risk, identifying risks, understanding them (likelihood, impact, and priority), and then preparing for them in advance has proven its effectiveness in numerous situations, including the armed services. It’s helped its users take more control over the full range of risks they face, rather than have risk control them. It has also minimized the occurrence of painful negative surprises, and created less anxious, more confident, ready-for-anything, risk-wise investors and financial planning practitioners alike.
Michael T. Carpenter is a 35-plus year veteran of the investment business and the founder of Carpenter Associates (www.MCarpenterAssoc.com), a Boston-based strategy, sales, marketing, and risk management consulting firm. He is the author of The Risk-Wise Investor: How to Better Understand and Manage Risk. Email author HERE.