Risk – It Means Different Things to Different People

Every student of behavioral finance understands that emotions trump data. In other words, we tend to base our assessment of the probability of risk on emotions and rationalize that we have done so using objective data.

Any discussion of risk should involve two key factors: probability and magnitude. Let’s take an example. You hop on a flight from Atlanta to Washington, DC. As you’re pulling away from the gate, the flight attendant comes on the PA system and says, “If you’re sitting in row 30 or higher, there’s a 10% chance we’ll run out of peanuts before we get to your row.” Low probability/low magnitude.

Now, as you’re taxiing to the runway, the pilot makes this announcement: “Welcome to United flight 207. We’re about to take off for Washington, DC. We’re proud of our safety record and I want you to know that 90% of the time we land in Washington without crashing.” Same probability/totally different magnitude.

In their book, Denying to the Grave, Why We Ignore the Facts That Will Save Us, authors Sara and Jack Gorman suggest, “We’re tolerant of risks that are familiar, frequently encountered, or part of a well understood system.” This explains why more people have a fear of flying than riding in a car, although the data doesn’t support this conclusion.

When investing, it is important that your advisor has a clear understanding of your feelings and beliefs about risk. Then, when making choices, understand that there are essentially four choices when it comes to handling risk.

1. Avoid the risk – This would mean staying out of the market completely. At the same

time, this inserts the additional risk that the rate of growth won’t keep up with inflation.

2. Control the risk – This could be done with proper asset allocation in order to mitigate the volatility of a portfolio.

3. Accept the risk – If you have time on your side or have more than enough money, this might be a viable option.

4. Transfer the risk – Use products like CDs, treasury bonds or Annuities to transfer the

investment risk to others and maintain a principal guarantee. The same thought process could be employed when considering life insurance for your family.

1. Avoid the risk – You could become a hermit and never leave your home or never drive a car.

2. Control the risk – You can limit your risk exposure like never drinking and driving or not taking those skydiving lessons.

3. Accept the risk – You may like to scuba dive; you can accept the risk of a shark attack by understanding your limits and avoiding those actions that make you look like lunch.

4. Transfer the risk – Use the law of large numbers to transfer the risk of an early death to an insurance company.

One final thought. In any discussion about market risk, be sure to “put pants on it”. For

example, if you are discussing the probability of a 15% loss on your retirement account, you may feel comfortable accepting that level of volatility. However, if your account is worth $1 million, could you live with a $150,000 loss? The risk of a 15% loss may sound minor – until you “put pans on it."

If you have a question for Tom, enter it in the comments below.

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Tom Kestler has been involved in the financial planning field for over 45 years. He is a graduate of Millersville State University and the College for Financial Planning in Denver, Colorado (for which he has acted as an adjunct instructor) and carries the Certified Financial Planner (CFP) designation.

He has also been awarded the Chartered Life Underwriter (CLU), Chartered Financial Consultant (ChFC) and Chartered Mutual Fund Counselor (CMFC) designations from the American College in Bryn Mawr, PA. He was the founder of Kestler Financial Group, Inc., a firm which specialized in the marketing of financial products and services to over 5,000 independent representatives throughout the United States. Kestler Financial Group was acquired by Highland Capital in 2018.

Mr. Kestler carries Life, Health and Variable Products licenses in several states and provides consulting services to insurance companies on product design and development. He also acts as an expert witness in securities and insurance litigation cases.

Prior to his retirement, Tom served as VP Advanced Sales at Highland Capital, and also CEO of Branch Development Partners, an Office of Supervisory Jurisdiction (OSJ) for Securities America, Inc. (now Osaic), an independent securities broker/dealer.

Tom is teaching our Financial Wellness Course— the next class is scheduled for Monday, January 26th. Sign up today!

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