I’m the son of a middle school English teacher. He recently shared with me this exercise he does with his kids. He chooses a word that has a role in different parts of speech, asking them to use different examples of the word in different contexts (verb, noun, adjective, etc.) Try it out. How do you define the word “round”? It’s a shape, sure. It’s also a way to make math easier to digest, right? We could all go out to dinner and I could offer to buy a round, too. Completely different uses and definitions for the same word.
I’m reminded of Dad’s class lesson when I feel a bit disconnected in client conversations. I sometimes fall into the trap of thinking I’m speaking the same language as my clients, when sometimes, I’m not. The financial industry is full of words that in the real world may mean something a bit different than how the financial industry may define it. The word “risk” fits that bill.
The finance industry defines risk as something measurable. You may have heard it referred to as standard deviation, the mathematical term. It may be variable, but it still has known limits. With investments, we commonly call it volatility (although I sometimes call it “wiggle”), which is actually measurable. If you think about it, measurable risk is why insurance companies are so profitable.
From my experience, my clients seem to define risk differently. In everyday life, we tend to think of risk as uncertainty. It’s the unknown. It’s what’s left over after we’ve thought of everything else. We tend to chalk risk up to being something that we simply can’t identify or can’t control, and thus, may want to completely avoid.
Those are two very different definitions. And would explain why, at times, its hard for me to communicate why I think it’s ok to take risks when planning for the future.
What I need to better communicate is what the word risk, within known limits, means. My definition isn’t talking about the odds of losing everything we’ve worked hard for our whole lives. It’s about taking risk with parameters. It’s about understanding the trade-offs between the best and worst case scenario, and assessing that the worst-case scenario still doesn’t mean jeopardizing everything. It’s calculated. It’s not too different than the forecast saying 75% sunny, only 25% chance of rain, and feeling OK about that picnic you planned.
Once we learn to recognize that we are not talking about the same “risk,” we can assess the trade-off between the important financial decisions you have to weigh. Insurance or no insurance (the act of transferring risk)? Do you invest in bonds or equities or do you park our life savings in cash?
Dad has a Webster’s to reference for his kids. There isn’t a universal financial industry dictionary for consumers. All the more important that you make sure you and your advisor(s) are talking the same language, especially when it comes to setting the right expectations on something as emotional as “risk.”