The Riskiest Risk


Today I am going to provide you a tool to help you really understand the largest risk to any investment or strategy a financial advisor may recommend to you. It's so simple it will seem silly, yet it is also very powerful. The risk you truly need to be concerned with and the risk that can harm your financial well-being more than any other is the risk that a financial advisor pooh-poohs away as being too big and too unlikely to need to worry about. 

The conversation could go many ways, but ultimately the financial advisor will make a statement to the effect that worrying about a certain risk is useless because it means something has gone so fundamentally wrong that there are much bigger worries. What the advisor is really telling you is that they do not understand that risk and do not know how to manage or quantify that risk. 

I do not like to speak or write in absolutes, but I am making an exception. NEVER follow a strategy or accept an investment recommended to you that your financial advisor does not really understand. If they cannot properly explain the risk and instead use arguments with no substance, do not consider that recommendation any further. 

I have listed a few examples of phrases to listen follow below:

  • If company X can't meet its contract guarantees, we have bigger problems than your investment failing. 
  • The risk in this investment is different.
  • This company has never had problems in the past. If it has problems in the future, our economic system has been so deeply hurt that no investment can survive.
  • That risk of X happening is extremely small and unlikely to happen. If it does, we have much larger concerns to deal with.
Any derivative of one of these statements is not an explanation of risk. It is simply a way to avoid having to acknowledge that the risk is not well understood. If we have learned anything over the past couple years, it is that those unlikely and misunderstood risks are what can truly derail financial plans and financial well-being. Those are the risks to be avoided. 

Our economic system did teeter on the brink of total failure. Companies never expected to fail collapsed (or only survived with historic government intervention) virtually overnight. Yet, the sun rose the next day and we had to continue to live our lives. We had to continue to think about our financial well-being and future financial selves. We did not have the luxury to not worry about the damage done to our finances because what had happened was low risk.

Avoid these types of risks at all costs. Call your financial advisor out when they do not explain a risk to you and instead use an empty explanation. Your financial advisor is not being malicious or trying to deceive you. They likely truly believe what they are saying. Nevertheless, they are doing you a disservice when recommending something who's risk they do not truly understand.
 

2 comments:

Benjamin said...

Nathan - I would say more often than not this scenario plays out when discussing the US/global economy...the adivsor will usually say - "If faith in the system is lost, it doesn't matter what your invested in..." Fun scenario to talk about - no. Easy scenario to understand/comprehend - no.

To your point if the advisor doesn't understand all the inherent risk (x-global financial ruin) of a specific investment decision, you probably shouldn't put your money there. But often times, these comments have to do with the entire global economy/market.

We have never fallen off the cliff, but some would say we have come close a few times. We all know falling off the cliff is a remote possibility, but a planners inability to define what this risk is doesn't necessarily mean a client should avoid this risk at all costs. Uncertainty is the price you pay for higher returns - give and take.

A client may want to avoid this doom and gloom scenario, they may not - that is dependent on their financial planning and goals. If they have higher objectives, it may be very appropriate for them to take on this uncertainty, whether their planner can define it or not.

Even if a client wanted to avoid this risk, how would they do that? Guns and butter is the old joke, but what's the other scenario?

Nathan Gehring, CFP®, EA said...

Benjamin,

I agree with what you have written...all of it. My point was not that risk should not be taken, instead that when a risk is not defined or articulated by a financial advisor warning sirens should be going off like crazy.

Take a look at your own explanation of this potential doomsday scenario; you have articulated what the risk is, acknowledged that it's a difficult risk to contemplate and discuss and quantify, and then laid out reasons to accept that risk or not. You have not simply indicated that the risk of total economic failure is not worth discussing, as I have heard advisors do.

It's not the actual risk that I think needs to be avoided. What needs to be avoided is accepting a recommendation with an inherent risk which a financial advisor does not truly understand.

Thanks for the comment, and good points made. Risk does need to be taken to achieve reward, just make sure the risk is understood.

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