You don’t see people covering themselves in bubble wrap to avoid breaking an arm if they trip on a stroll in the park. I don’t know people who stay home 24/7 to avoid a car accident. And I don’t think many people avoid eating out for fear of food poisoning.
But when it comes to personal finance, people often seek to avoid all risk. This may mean owning mostly bonds and cash with very little stock. It may mean putting all their net worth into laddered CDs. Or it may mean putting most of their money into annuities.
There are several problems with trying to avoid risk in your personal finances:
- Instead of avoiding risk, you typically just substitute one risk for another. Yes, you can minimize the impact of stock market risk by owning little stock. But you have simply traded one risk for another. For example, short-term bonds and cash almost certainly will not keep up with inflation over a lifetime. By contrast, stocks will almost surely beat inflation over a long period, partly because companies can raise prices. So, you have substituted market risk for inflation risk.
- To afford your goals, you almost surely need to take some risk. Very few people have so much or spend so little that they don’t need to generate a reasonable return from their investments.
- Risk is impossible to identify in advance, so it’s impossible to avoid. Who in 2019 anticipated a global health pandemic and bought a year’s supply of toilet paper, hand sanitizer and face masks in advance? Going farther back in time, who in 2005 predicted a global housing crisis and sold their real estate? Who in 1987 said the stock market would fall almost 25% in a single day and sold all their stock? Who in 1970 predicted a gallon of gas would cost 4x as much as it would a decade later, and either traded in their large car for a small one or moved to be closer to public transport?
The right approach is to manage risk thoughtfully – not to run from it. Here are a few basic strategies:
- Determine how much stock you can comfortably own – and own that for the long term, regardless of market ups and downs. That calculation is financial and emotional. The financial element calculates how many safe assets you need to avoid selling stocks to cover expenses. The emotional calculational is harder and highly personal. Spend time carefully thinking through both.
- Avoid putting too much into any one kind of investment. Putting a large percentage of your assets in real estate, an annuity, your employer’s stock (see our recent blog here), technology stocks, municipal bonds, or any relatively narrow category exposes you unnecessarily to risk. It is always better to diversify.
- Keep a cushion of very safe investments – cash or short-term, high-quality bonds. That will give you a resource for spending in an emergency or an extended economic crisis.
Risk is everywhere and often shows itself in the last place you expect to see it. Plan for it.