4 Ways to Better Understand Risk in Your Personal Finances
Recently, Dr. Aaron Carroll wrote a wonderful article on COVID-19 and personal risk for the New York Times. The article dove deep into how we, as humans, assess risk in our daily lives and how that normal assessment of risk doesn’t actually match up well to the realities of the life challenges we face.
Here’s a key quote from the article:
“Too many view protective measures as all or nothing: Either we do everything, or we might as well do none. That’s wrong. Instead, we need to see that all our behavior adds up.”Dr. Aaron Carroll
Carroll’s central point is that risk in most areas of life is additive — not all or nothing — and it’s something we often get wrong in our lives, particularly in finances.
The same thing pops up with retirement investments. “Should I invest in stocks?” might seem like a simple yes or no question, but it’s not. You could put half of your retirement money into cash and half of it into stocks, and you’ll see a middle ground of short-term changes in value along with solid long-term returns. If volatility worries you too much, just move some of your volatile investments, not all of them, and find a better balance. It’s a spectrum, not a yes or no choice.
4 strategies for managing risk in your finances
1. Put some sensible limits on things
Rather than looking at your choices as being all-or-nothing, decide to put reasonable limits on things and live by those limits.
Why does this work? With most things in life, there’s a fulfillment curve in play. Eliminating all spending on something you love leads to misery, but having too much of it turns into quickly diminishing returns, where it becomes routine. When it becomes routine, however, you’re continually taking on risk and/or expense without much additional value for each time you indulge.
We often turn this into an either/or choice, but the truth is that there’s a happy medium. Buying Kindle books at a rate that matches my reading pace (along with library books) is a good example — if I just let myself have free rein, I’d spend much more but just wind up with a ton of unread books.
Set a clear limit for yourself upfront and follow that limit, like only five Starbuck coffees a month. You’ll find that most of the value you get from that experience is already present with a relatively low portion of the risk and expense.
2. Automate as much as possible
One element of risk that people often overlook is our own poor decision-making in the heat of the moment. For example, we might come up with a great investment plan, but we choose not to actually invest each month, or we have a great debt repayment plan, but it falls apart because we don’t make that extra debt payment.
One great way around that is to automate your decisions as much as possible. Figure out a good financial plan and then make that choice automatic going forward.
A great example of this is retirement savings. Rather than relying on yourself to continually remember and choose to do it manually, instead you set up an automatic contribution to your retirement account from each paycheck or an automatic transfer each month into your emergency fund.
How does automation apply to non-financial choices? You might choose to set up a weekly meet up with your friends in a park and put that as a scheduled event in your calendar, then choose to minimize social contact outside that. Scheduling repeated events makes it easy to just do them and stick to them with minimal thought or decision-making. This is known as time-blocking or block-scheduling.
3. Diversify your investments and personal choices to match your risk tolerance
All of us have different risk tolerances, both in finances and otherwise. This isn’t just due to how we internally see the world, but also due to differences in our lives. A parent living at home with a child who has an autoimmune disorder is likely to react very differently to COVID-19 risk than a single young person in perfect health. That has little to do with their internal risk tolerance, but rather, the things they have on their plate to be concerned with. Different people value things differently — some people get less value out of big social gatherings, so they might view the reward they get for the risk as being less worthwhile for them.
The same is true with finances. Some people can simply tolerate risks to their finances more than others, and the same person might change the relative risk of their investments throughout their life as their situation changes.
Here’s the key: learn about the decisions you need to make and think about your level of risk that’s acceptable to you, and make personal decisions. You don’t have to follow the recipes and rules set up by a financial guru or by your friend down the street. Instead, spend the time to learn what’s going on from a variety of sources, not just the ones that reinforce what you already think and then make choices that reflect the amount of risk you personally tolerate. Be strong and confident in those decisions.
4. Focus on process over immediate results
A final strategy is to always look at the big picture of your individual small decisions and focus on the overall process rather than the immediate results.
A dieting analogy is really fitting here. Many people want to see immediate results when they make a dietary change, but the truth is that significant change in one’s weight takes time. It is not the result of choosing not to eat ice cream once, but rather the culmination of many individual choices. Focus less on that individual decision to eat or not eat ice cream and rather look at how that decision is part of an overall picture. What is the big process here? Or, to put it another way, what would the healthy person you’re becoming choose here?
With your finances, don’t get hung up on the temptation of a particular purchase in the moment. Rather, step back and look at the big picture, the one that balances pleasure in the moment with the long-term goals you have for yourself. Again, trust the process rather than the temptation of the moment.