Risk is part of our human existence but we continually search for ways to lessen this risk wherever possible. Another part of human nature is the need to protect our resources so that we can consume these resources in the future.
In today’s topsy-turvy, crisis centered world it’s particularly important to understand risk. You can’t totally eliminate risk but you can make sure that your risk level lines up with the risk you need to achieve what’s most important to you.
It’s easy to get lost in all the types of risk but one of the most pervasive, yet invisible varieties of risk is the type associated with your career, your business, or your job. Economists call this career capital and for many investors this is their largest asset, yet it doesn’t appear on any net worth statement.
Many corporate employees accumulate significant amounts of employer stock over time, which has the effect of doubling down on their risk level by having their career capital and financial capital in one place. This dramatically increases your risk level well beyond anything that is reasonable. This lack of diversification can extract a huge price if everything doesn’t unfold exactly as planned.
Take the Free Lunch
Investors focused on protecting future consumption should take advantage of the risk lessening avenues broadly available in the markets. Specifically, as famed economist Dr. Harry Markowitz has written, “diversification is the only free lunch” in finance. What this means is diversification helps smooth out overall performance without sacrificing much in terms of long-term returns.
Some of you have seen the year by year chart we often use in the office to demonstrate how a well-diversified, 60% stocks/40% bonds, portfolio has fared versus the S&P 500 Index (which only contains very large U.S. stocks). Over the past 20 years, the 60/40 portfolio has outperformed the S&P 500 even though it has less risk.
Of course, investing is just one component of lessening risk. What you do after you invest and how well you avoid the terrible temptations of reacting to day-to-day meaningless noise is a critical factor in reducing risk.
Think about the individual parts of your financial life as if these were your car. If you have a couple of flat tires and the engine is sputtering, it doesn’t really matter how nice the interior is…the car still won’t function properly. The car requires that all the parts work together. If your investments look good but you lack a reality-based plan for achieving what you want, ultimately you will have difficulty mustering the behavior needed to follow through on your financial plan.
Without a plan grounded in reality (and NOT overly focused on investments), you will be very apt to make BIG MISTAKES. Avoiding these BIG MISTAKES is the most valuable part of real financial planning. Start there.
Related: How To Deal With an Imprecise Life