Risks Are Everywhere

Saying that “Risks are everywhere!” isn’t necessarily a profound statement, but it’s important to recognize from a high level that there are risks present in every aspect of our lives.  In most cases, we generally handle the risk by either avoiding it, knowingly accepting the risk, reducing the frequency or severity of the risk, or transferring the risk to either another party or an insurance company.

A probability/frequency vs severity matrix is a great way to illustrate the different types of risks inherent in our lives and how we should handle the risk:

Each of the four quadrants represents a unique category of risks that should be handled differently based on the probability of occurring and the potential negative impact it may have when it occurs.

• Low Probability, Low Impact – The risks present in this lower left quadrant are the type of risks that people generally accept, or ‘self-insure’, because it’s not worth the time, money, or effort put into either reducing the chance of the risk or reducing the impact if it already happens very infrequently and isn’t a big deal anyways.  An example of this would be the risk of bouncing a check or having insufficient funds available on a debit card if someone leaves little reserves in his or her checking account and an unforeseen expense comes up, such as a car repair is needed.  In this example, the person could ‘self-insure’ by keeping a rainy day fund (i.e. an emergency fund) available to cover the unforeseen expenses.
• High Probability, Low Impact – When recognized, the risks that fall in the upper left quadrant are often reduced or avoided through a noninsurance transfer.  An example of reducing the risk of sunburn when spending the day at the beach is deciding to wear 50 S.P.F. sunscreen. In another example, a noninsurance transfer would be for a landlord to have his tenant sign a hold-harmless agreement, which transfers the liability over the the tenant when he/she accepts all responsibility for injuries occurring on the rented property.
• Low Probability, High Impact – This is the perfect scenario for using insurance, as illustrated by the lower right quadrant. People are able to use insurance companies to share pure risks (involving either loss or no loss) among many individuals to take advantage of the law of large numbers. Each individual, thus, only pays a small fee to know that, if the low probability event occurs to them, they will be insured from taking on the massive impact they otherwise would’ve experienced. One common example is buying homeowners insurance to reduce the impact of the house burning down; even though there’s a very small chance of any particular person’s house burning down, almost no one is willing to take on that risk that they could potentially lose everything they own in a single house fire.
• High Probability, High Impact – Catastrophic risks are present in this upper right quadrant, and they are often best handled through avoidance. In this group of risks, insurance is usually not an option because it’s either too expensive or not offered.  For instance, one could simply avoid building a house too close to the high water mark of a river or ocean, especially if it tends to flood or be struck by hazardous conditions during spring/hurricane season.

This probability vs impact framework is useful to understand when referencing perceptions of risks in many aspects of life.  This matrix is often used when discussing the need for insurance, but it can also be applied to the framework of investing.  One of particular interest to me is the risk inherent in investments, measured in a variety of different ways, commonly referenced as standard deviation or maximum drawdown.  Since the S&P 500 fluctuates regularly and has historically always recovered after major drawdowns, the risk of drawdown for the S&P 500 fits well within the upper left quadrant (High Probability, Low Impact), especially if investing during someone’s early years of life.  Stocks generally will significantly rise and fall dozens of times during each investor’s wealth accumulation phase of life, and most investors can take on the majority of this risk early in their life with a long time horizon ahead to smooth out the bumpy ride to retirement.  With that said, as the time horizon decreases and an investor approaches retirement, the number of large swings the person is expected to experience will be reduced, as a function of less years to invest, which shifts the risk down toward the bottom box; at the same time, the sequence risk during the first few years of retirement when the retiree first begins withdrawing funds shifts the risk to the right, because beginning to withdraw money from an investment after it falls has devastating effects on the money’s ability to compound over the coming years.

This tendency for an investor’s portfolio to begin in the top right quadrant in an investor’s early years and to shift toward the lower left quadrant by the retirement years is the reason why investors tend to progressively increase their bond allocations over the course of their lives to reduce risk.  Theoretically, bonds provide a stable portion that might even rise in value when stocks fluctuate downward, and by adding this stable/uncorrelated portion to the portfolio, it could potentially have both fewer and less severe drawdowns than holding a portfolio made up of entirely stocks. With that said, I don’t necessarily think the traditional approach of combining stocks and bonds is the best way to managing investment portfolio risk to match a person’s risk tolerance; however, it’s a good framework to start the discussion.  As I plan to illustrate in future blog posts, understanding risk in the context of building investment portfolios is essential to making well informed decisions of how to best achieve your individual financial goals.