Opinion
Why this is the most poorly understood thing in finance
Paridhi Jain
Money contributorYou want to know the one financial concept that, I think, is the most poorly understood, and therefore contributes the most to poor financial decisions? Risk.
Here are some examples of the gross misunderstanding or fear people have of risk in the context of personal finance. Maybe they sound familiar?
When it comes to making money taking risks is often unavoidable, so don’t be scared of making the leap.Credit: Simon Letch
- Are you far more willing to take on the risk of a half-a-million dollar mortgage to buy a property than you are to risk a few hundred dollars in the share market?
- Are you scared of putting your superannuation into a ‘high-growth’ portfolio, even though you’re in your 20s or 30s and have decades to ride out any market movements before you’re eligible to access your superannuation?
- Are you so scared of trusting a professional to help you make financial decisions that you end up taking on the bigger risk of making no decisions?
If you said yes to any of the above, you might need to rethink your understanding of risk.
If you didn’t quite catch the theme, you’ll notice that in a lot of the above scenarios, the decision that ‘feels safer’ is actually riskier than the perceived risk you’re trying to avoid.
Why is risk so poorly understood?
You’ll start to see that everything has risks associated with it. There is no risk-free option.
One major reason is because most people confuse fear and risk. You hear a few horror stories, so you think it’s risky but, actually, you’re just scared. You hear something is safe, so you feel less scared, but you haven’t actually evaluated the risks of both options.
Fear is a feeling. Risk is not. Fear isn’t something you typically quantify. Risk is. The strategies you use to reduce fear are not the same strategies you use to reduce risk.
So, how do you start to dismantle this fear and develop a better understanding of risk?
1. Start to get clear on what risk actually is. Most people talk about risk in a very black-and-white way. Something is either risky, or it’s not. Shares are risky and real estate is not. Starting a business is risky and a job is not.
This isn’t the correct way to think about risk. Instead of asking whether something is risky or not, start asking: “What are the risks associated with this decision/activity?”
For example, investing in real-estate has risks. Taking on a mortgage is risky. There are risks associated with the type of building you buy (apartments versus houses).
In contrast, the share market has other risks associated with it. If you buy shares in a specific company, you’re buying into all the risks that impact the viability of that business. There could be risks associated with the platform or service you choose to buy investments through (for example, the broker, the financial adviser etc).
You’ll start to see that everything has risks associated with it. There is no risk-free option.
If this feels terrifying to come to terms with, that’s not such a bad thing. Chances are, until now, you’ve been using the illusion of safety as a way of protecting yourself from the reality that risk is everywhere and in everything.
2. Instead of avoiding it, learn to manage it. Since most people fear risk, the default behaviour is to try and avoid it. Hopefully by now though, you’re getting that this isn’t really an option.
Since risk is everywhere, your chosen avoidance strategy comes with risks too. So, if you can’t run from it, you might as well face your fears and learn how to deal with it.
The great news is, like most fears once you face them, it’s usually not as bad as you thought it would be because you realise that there’s a lot you can do to mitigate risks.
For example, you can reduce the risks associated with buying the shares of a single company by investing in an exchange-traded fund or index fund which gives you exposure to a broad variety of companies (i.e. the risk mitigation strategy of ‘diversification’).
You can manage some of the risk of losing your money in a recession by investing in assets you plan to hold for a long time horizon, which means your portfolio will have more time to survive and recover from any market downturns (i.e. using ‘time’ to mitigate risk).
Once you learn how to manage risks, you’ll see that risks aren’t a take-it-or-leave-it deal. There’s a lot you can do within your control to reduce and manage risks too.
This is the sweet spot that much of financial success boils down to: not reckless risk taking or head-in-the-sand risk aversion, but taking informed and calculated risks.
Paridhi Jain is the founder of SkilledSmart, which helps adults learn to manage, save and invest their money through financial education courses and classes.
- Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.
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