Updated on 01.15.11

A Simple Rule for Risk Assessment

Trent Hamm

So much of life boils down to the simple idea of risk. Every choice we make has some chance of a negative result, and being able to assess the chances of that negative result helps us figure out which choice to make.

In day to day life, we make tons of quick risk assessments all the time. Jumping down from this ledge is too risky. Speeding a little is worth the risk, but speeding a lot is not worth that added risk. Is it worth the risk to our friendship to tell my friend what I really think?

However, the more complicated the situation, the worse we tend to get at such quick risk assessments, but we still rely on them far too often.

Is the risk of this car loan worth it in order to get that shiny new car?

What about the risks associated with buying this not-really-necessary item and raising our credit card balance?

Should we put our money into stocks or leave it in a savings account?

So often, the reader mailbag questions I get boil down to a simple question of risk assessment. A person is having a hard time determining which path in their life is more risky and they’re asking for my input.

In the end, what I usually do is put myself in their shoes and use the same simple rule for risk assessment that I use for myself when I’m unsure of a situation.

Here’s that rule. Whenever you’re thinking of taking some significant risk, ask yourself this simple question: is the worst (reasonable) case scenario tolerable for me? If it isn’t, find a more conservative option. If it is tolerable, then that risk is acceptable.

Of course, actually knowing what that worst case scenario is and how likely it is requires some research in most cases.

For example, if you’re trying to make a decision about an investment of some kind, it’s good to know the history of such an investment and the history of such similar investments. This way, you can understand what the worst historical scenario is, and I usually assume that the worst case scenario for me is about 10% worse than the worst historical period of the same length.

Another example: if you’re trying to make a decision about life insurance, imagine that you pass away two days after getting the insurance. What happens to your family in that case? Is the money you’re leaving behind via the insurance and your estate enough to cover their needs with some room to breathe?

I’ll give you a third example from my own life. My wife and I have been struggling with various health care options as she returns to work, since she has something of an open enrollment period now. One of my assessments of the options – perhaps the most important assessment – was a scenario in which one of the members of our family had a very long illness, such as cancer, that required extensive care. What would happen to us under each health care plan? Would we be able to survive? We eventually chose a plan that offered a high deductible for individual treatments, but great coverage for such long-term illnesses, as that plan offered a benefits package that matched what we could do for ourselves financially.

The worst case scenario is a spectacular guide for every major financial decision you need to make in your life. What happens to you in that worst case scenario? Is it something you can financially live with or not?

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  1. kjc says:

    Hmm… I fear that constantly worrying about worst case scenarios may make one overly cautious.

    This post reminds me of T. Harv Eker’s Secrets of the Millionaire Mind. One of the tenets Eker advances is that rich people CREATE their lives, and poor people believe that “life HAPPENS to me.”

    Isn’t it a bit passive, or doesn’t the possibility of passivity exist in a constant focus on “what’s the worst thing that could happen?”

    After all, let’s say I’m considering a certain investment. What’s the worst that could happen? 10% worse than historical poor performance is an inadequate test, in today’s world. The worst that could happen? Someone detonates a dirty bomb on Wall Street, in DC, or London. What do you invest in, given that possibility? A mattress?

    Sorry, this approach seems overly simplistic.

  2. Riki says:

    For me, focusing on the worst-case means I’m making a decision from a place of fear. I don’t want to live my life that way.

  3. valleycat1 says:

    Wouldn’t the worst case in your insurance example be that your wife is the one who quits or loses her job or passes away, so you need to be saving money or protecting your assets for when you no longer have insurance but might still experience one of the other instances?

    Speaking from related experience in our life, where my husband (a farmer) decided planting 10 acres of one crop to sell commercially would be a great deal. The worst case he came up with was that the price on that crop would plummet, but he’d at least break even. The worst case actually happened, but turned out to be the crop developing a disease so that we didn’t harvest a single onion.

  4. LeahGG says:

    @kjc: I think it’s not supposed to be looking at it from the absolute worst possibility in the universe but from the worst likely scenario. If you’re trying to decide whether to get another degree and take on debt, then you need to look at the job market for people with that degree. If most people graduating with that degree are getting a job within 3 months, then your “worst case” should be that you get a job within 6 months. If most people are getting a job only after a year or two, then your “worst case” would be being jobless for 2-3 years. If you can’t stomach the worst of the likely scenarios, then you should make alternate plans.

    Sometimes, the reality is entirely different from your worst case scenarios (see Valleycat’s situation) and you have to roll with the punches anyway somehow.

    On the other hand, most of the time, the reality is somewhere between the most likely best case scenario and the most likely worst case scenario.

  5. Telephus44 says:

    I think that this entire concept – and the reason why people write in with questions about risk – hinges on the word “reasonable” – “is the worst (reasonable) case scenario tolerable for me? ” I think many times the advice given assumes worst case scenarios that are beyond “reasonable” to consider. For example, I want to buy this house. But what if you get laid off while your wife is pregnant with triplets and your mom gets cancer and your car dies? You wouldn’t be able to handle all that plus a mortgage payment!

    To take Trent’s first question of taking on a loan to buy a new car – what is the worst (reasonable) scenario I can think of? I could get laid off, and would have to cut my grocery bill in half and stop eating out to make the car payments. I can live with this.

    I think many people in the personal finance sphere are absolutely risk averse, and spend too much time dwelling on unreasonable worst case situations, and not only hold themselves back from making constructive risks, but constantly advise others to do the same.

  6. Reality has no bound on reasonable. When we bought our house, got one so we could keep even if I could only make 1/3 of my current pay. too bad things went south and I could only make 1/6.

  7. Jeffrey says:

    This is a great post and is a rule I definitely strive to live by. However, I think it’s harder for the majority of people to accept the “worst case scenario” when it involves anything but a very conservative idea. Many stick with jobs they hate because they can’t imagine life with a lower income than they have currently. I also think some suffer from not being able to objectively assess the possible scenarios that they could face. Nonetheless, this is a great challenge to get you thinking about choices in work and life.

  8. ABQBrent says:

    Not only is it a problem to focus too much on the worst case scenario, but sometimes not looking at the best case, or the average case is bad. The worst case on a lotto ticket is losing a couple bucks, that’s acceptable to me. The downside is that the worst case is also by far the most likely. Not only should you only take the risk you can afford to, but you should only take the risk that benefits you.

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