Finding Your Comfort Zone with Risk

Let’s play a quick game of “Would you rather?”

Would you rather have a certain $3,000 or an 80% chance of $4,000?” Most people choose a certain $3,000, even though the 80% chance at $4,000 has a higher value ($4,000 X 0.80 = $3,200).

In fact, a computer would pick the 80% chance every time. But investors have different relationships with risk. They tend to focus on the benefits of the $3,000 as well as the 20% chance they could have nothing.

This phenomenon is called Prospect Theory, and it helps explain why some people are more comfortable with market volatility and others prefer a different approach to risk management.

You Can Avoid, Manage or Transfer Risk^1,2

Every time you drive your car you face the risk of an accident. So, what do you do? You can avoid the risk altogether and order take-out food for dinner, or you can manage the risk by putting on your seatbelt and driving to the grocery stores. You could also transfer the risk by calling a car service, and have them pick up whatever you need.

The same principles apply when you are seeking your comfort zone with investing risk.

Avoiding Risk

You can always put your money under your mattress or you can put money in a bank, but remember, even banks have limits. They insure deposits only up to $250,000 per depositor per institution for each ownership category. So, even pursuing safety and security can have challenges.

Managing Risk

You can’t control financial market volatility, but you can manage the risk. With asset allocation, for example, you can manage risk by holding investments that align with your time frame, financial needs, and comfort with market volatility. But even asset allocation has limits. Asset allocation does not guarantee against loss, especially in a declining market.

Transfer Risk

Transferring risk from one entity to another is another approach. With an annuity, for example, you can transfer the risk of running out of money in retirement to an insurance company by purchasing an immediate or deferred-income annuity with a lifetime payout option. But remember, the guarantees of an annuity contract are dependent on the issuing company’s claims-paying ability. Annuities have contract limitations, fees, and charges to consider, so it can be best to seek guidance if you want to transfer risk.

A Strategy for Risk

Sometimes, the best strategy for dealing with risk is a combination of avoiding, managing, and transferring. Knowing that you have a strategy in place can help when the financial markets have highs and lows that can test the mettle of even the most seasoned investors.

“Our tag line is ‘You Gotta Have a Plan.” As important as it is to ‘have a plan,’ it’s more important to let/allow God to direct your steps,” wrote Mick Owens in Diamond of Life: The Five P’s of Success and Significance. “After all, He created you and the stuff we often chase.”

How cfc Advisers Assess Risk

“How comfortable are you with risk?” is an almost impossible question to answer. So, to help you articulate your relationship with risk, we will walk you through a series of questions that are designed to help you “show us” what type of risk you can tolerate. Here’s an example:

Investing involves a trade-off between risk and return. Historically, investors who have received higher long-term average returns have experienced greater fluctuations in value of the portfolio and more frequent short-term losses than investors in more conservative investments have. Considering the above, which statement below best describes your investment goals?

• Protect the value of my account. In order to minimize the chance for loss, I am willing to accept the lower long-term returns provided by conservative investments.
• Keep risk to a minimum while trying to achieve slightly higher returns than the returns provided by investments that are more conservative.
• Focus more on the long-term investment returns. Long-term growth is equally as important as managing portfolio risk.
• Maximize long-term investment returns. I am willing to accept large and sometimes dramatic short-term fluctuations in the value of my investments.

There’s no right or wrong answer to the question. But it starts the process of helping us determine how we will avoid, manage, and transfer risk in your portfolio.