What are the three steps to better manage risk and get what you really want.
In this episode you’ll learn:
- Why goods and services that lessen risk tend to cost more.
- What is the three-step process for assessing and managing risk.
- Why defining the risk-free option or asset is critical to managing risk.
- Why immediate annuities are the retirement risk-free option rather than a conservative investment portfolio.
- What are the two types of risk and how do we mitigate them.
- What is the difference between hedging and insuring against risk.
Almost no decision is made without a certain level of risk attached, and it can be hard to know how to manage that risk, especially when it comes to our money. David unpacks how risk affects our everyday life, how we can accurately identify and assess different types of risk, and how to focus on what we really want. Be sure to listen to the entire episode for all the helpful tips and insights into healthy risk management!
Goods that lessen risk cost more…most of the time
Making decisions in the face of uncertainty is where knowing how to weigh risk comes into play. People are generally willing to pay more for goods and services where there is less risk attached. For example, David explains that once, he was waiting in line for a train that was supposed to come soon, but the line to get tickets was extremely long. He was running the risk of not catching the train. A man offered David a trip off of his 10-trip card for $5. The cost of a single ticket for the train was also $5. David decided to take the man up on his offer. The man knew that there was a demand for tickets, and he could have offered the trip on his card at a much higher cost. Because the man’s card was lessening the risk of missing the train, David would have been willing to spend more than $5 on it. The same idea applies to airfare costs. Some are willing to spend more on a ticket that reduces their risk of ending up in an uncomfortable, middle seat on the plane. This concept, however, doesn’t always work. Listen to the episode for an example of risk being taken at a possibly very-high cost.
How to manage risk in three steps
David shares strategies for how to manage risk from the book An Economist Walks Into a Brothel by Allison Schrager. In her insightful book, Schrager outlines three steps for assessing risk.
- Define the ultimate goal. What is it that you want?
- Identify how to achieve that goal without any risk or with as little risk as possible.
- Is the risk-free option what you want or need? If not, how much risk are you willing to take to achieve your goal?
Everyone’s goals are going to be different. David gives the example of selling his home at the same time as his sister was selling her home. While David wanted to sell his home because he didn’t want to face the cost of maintaining it through the winter, his sister wanted to sell her home at a specific price. Both received offers on their homes, and David took the lower offer given him because it mitigated the risk of having the home through the winter. His goal was achieved, and he did not counteroffer. His sister, however, did not take the lower offer given her because it did not achieve her goal of receiving a certain dollar amount. She took the risk of submitting a counteroffer to hopefully meet her goal. People’s “risk-free” options will look different depending on what it is they want.
Identifying risk and knowing how to de-risk
Knowing what type of risk you are facing can help you create a suitable strategy. Schrager explains two types of risk we often have to deal with.
- Idiosyncratic Risk: affects an individual asset and is specific to one situation.
- Systemic Risk: affects an entire system or a large number of assets/situations.
Idiosyncratic risk can be reduced by diversification in one’s portfolio. Warren Buffet recommended the 90/10 strategy for retirement funds—putting 90% into the U.S. stock market and 10% into T-Bills. Such a strategy would increase the systemic risk an investor would take because it would leave him open to any damage to the stock market as a whole. Diversifying asset classes and return drivers is one way to reduce systemic risk.
One way to “de-risk” is hedging. Schrager defines hedging as, “giving up your potential gains if things go well in exchange for reducing the odds of things going wrong.” Hedging provides protection from the danger of not meeting your goals, but it decreases the chance of exceeding your goals. It all goes back to what it is you want. Hedging is often thought of in financial terms, but its concepts apply to other areas of life. David uses the example of leaving his investment firm. His goal was the security of knowing that he would have a large enough nest egg to live on. With this as his goal, he let his partners buy him out over seven years. He gave up the opportunity to make a future career in investing for the security of consistent payments from the firm. The payments were his hedge. Though not entirely risk-free, they helped him achieve his goal.
Insurance is another type of de-risking. Listen to the episode to learn what makes a solid insurance operation and why insurance companies can afford to take on the risk of shouldering the cost of their clients’ disasters.
The freedom found in flexibility
An important part of effectively managing risk is knowing when to be flexible. The risk-free path is an option. It’s not the only path available. As new information comes to you, be willing to change your decisions. Having multiple options available can offset risk. David uses the example of going to a conference and having to decide whether or not to take a limited-time opportunity to buy cheap tickets for the same conference in the following year. While buying the cheap ticket reduces the risk of purchasing a more expensive ticket later on in the year, it increases the risk of being locked into attending the conference. If attending the concert turned out to be undesirable, then he could lose money. Choosing courses of action that provide room for flexibility can increase your freedom to make wise choices and help you avoid unnecessary risk. In the end, however, it all comes back to the question, “What is your goal? What do you want?”
- [0:17] Weighing the risk and knowing how to make a decision under uncertainty.
- [5:00] Three steps for assessing and managing risk.
- [9:11] Finding the risk-free asset in a retirement plan.
- [14:36] Idiosyncratic & systemic risk.
- [16:40] De-risking and using hedges to create a risk buffer.
- [20:22] Identifying a sound insurance operation.
- [23:36] Using flexibility as a risk management strategy.
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