Understanding Risk and How to Use It to Your Advantage

Understanding Risk and How to Use It to Your Advantage

The term “risk” is as important as it is hard to define. The dictionary defines it as “a situation involving exposure to danger.” Of course, the word danger itself is ambiguous. Danger could mean all sorts of things from physical to mental to financial hardship. That’s why the term “risk” is so important – it applies to all elements of your life. In its broadest sense, risk is simply the probability of a negative outcome.

Risk is essential to quality of life because it drives innovation, fosters growth and opens doors to new opportunities. Identifying risk is different from being fearful of something. If you just gauge your fear in decision making, you’ll get nowhere. But risk can help you make better decisions if you approach it objectively. When you make an important decision, including a financial decision, consider this approach to risk:

1. Identify all potential risks. Lawyers are trained to do this quite easily because we essentially have been trained to look for what can go wrong. You need to sit down and make a bullet list of all the things that can go wrong in your important decision.
2. Assess the risks. As to each risk you’ve identified, attach a likelihood (probability) of that risk occurring. In addition, determine the potential severity of its consequences.
3. Develop a risk management strategy. For each risk, based on its probability and severity, determine whether your course of action should be as follows: 1. Complete avoidance. 2. Mitigation. Perhaps a slight alteration in your plan can substantially mitigate the risk. 3. Transferring the risk to a third party. That’s what insurance is all about. If you buy a home on a lake to enjoy lake activities you have a risk of injury to people you invite over. Homeowners insurance transfers that risk to a third party. 4. Accepting the risk. Once you’ve identified the risk and its probability you can decide whether it’s worth simply taking on the risk to enjoy the potential benefits of your decision.
4. Often missed in identifying the risks of a particular endeavor is the risk of not engaging in it at all. In my financial planning business, people sometimes think that if they hold their money in cash instead of in equities they eliminate a huge risk of volatility. While that may be true over the short term, holding all or most of your savings in cash creates a huge inflation risk over the long term because inflation slowly but surely eats away at the buying power of your money. Historically, nothing fights inflation as well as owning stock in good companies.

Risk is inevitable in life. I can think of very few things that I have accomplished in my life that didn’t involve overcoming one or more risks. In fact, I abide by the adage that the biggest risk in life is not taking any risk.

I’ve tried to teach my sons that success in life is directly related to the amount of risk you’re willing to take. However, I’ve also taught them to break down the risk elements of a decision objectively as I set forth above. Hopefully, you will take the time to do the same when making an important decision in your life. Not only will it help you to identify risks, but it will give you much more confidence in your decision-making.