3. Understanding Risk
Because every risk is different for every individual, a critical element in demystifying risk is knowing and understanding the four characteristics of a risk that must be considered to manage 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?
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Direct exposure or indirect exposure?
(We don’t need to be concerned with risks we’re not exposed to.)
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In what context or environment does a given risk occur/not occur?
Likelihood: What is the likelihood/probability of the risk occurring?
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High, moderate, low?
Impact: Should a given risk occur, what impact (short, mid and long-term) will it have on the individual and/or investment approach/investment vehicle or portfolio?
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None, low, moderate or high?
Resilience: Should risk occur, what’s your ability or what resources do you have available to help bounce back and/or recover from its impact over the short, intermediate and longer term?
Of all the factors above, which is the most important? (For the answer…See the next section)
4. Prioritizing Risk:
Which Risks to Avoid, Accept And Manage Or Accept Outright
Since managing risk has a cost (in time, money, attention or other resources) and you can’t protect against everything (since doing so reduces your risk as well as your potential upside), it’s critical to prioritize your risk management resources and attention, and focus on your highest priority risks.
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.
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High impact/high probability
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High impact/moderate probability
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High impact/low probability
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Moderate impact/high probability
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Moderate impact/moderate probability
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Moderate impact/low probability
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Low impact/high probability
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Low impact/moderate probability
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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 is in how it can adapt to each client’s or each portfolio’s specific investment purposes and priorities.