Risk Assessment Holds The Key

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Risk Assessment Holds The Key
It’s important to understand the risks properly before trying to navigate through the turbulence
Larissa Fernand - 28 February 2023

Risks exist in every single aspect of our lives. Yet, it cannot be easily expressed, because it means different things to different people.

That is why, when evaluating what the risk of a particular asset allocation or an investment product is, one must view it in a very specific context and how it fits in with one’s life and personality.

I list down three stories that will drive home my point.

The right experience matters

I can never forget the narration of Jason Apollo Voss, chief executive officer of the US-based firm Deception And Truth Analysis Inc.

Years ago, his daughter went on a week-long river rafting and camping trip. This was the scheduled annual trip organised by her school, so it was not exceptional. However, there was heavy snowfall the previous winter, and so, the river was swollen with fast rapids. Worse, the forecast for that week had predicted heavy snowfall and freezing temperatures.

On the very first day, the rafts capsized. The students were in danger of suffering from hypothermia. Most of the food and medical supplies were lost to the river. Yet, the instructor in-charge refused to return and decided to persevere through the rest of the week. Consequently, several of the students had to be hospitalised.

When the parents demanded an explanation, the school authorities informed them that their instructor is extremely experienced, and had led these expeditions for over a decade without any incident.

What went wrong?

The school administration engaged in an incorrect risk analysis of the instructor’s experience. The relevant experience for the situation was not how many years of expeditions he had led (wrong context). The relevant experience for the situation was how many expeditions he had led where everything went wrong, and from the very beginning (correct context). It turned out that the instructor had never really come anywhere close to experiencing these difficulties in the past.

Financial Implication: This is why investors prefer experienced financial advisors who have gone through various bull and bear markets. They understand what is at risk and how to navigate the turbulent market upheavals.

What’s risky for you, may not be risky for me

Kat Cole is the chief operating officer of the food company Focus Brands

When she was at university, she worked as a waitress at an American restaurant chain. She excelled, and was also named the best employee. They requested her to go to Australia to train employees at a new franchise. At that time, she was not in possession of a passport and had never stepped on a plane before. She grabbed the opportunity.

Her studies began to get severely affected. She had no powerful and connected friends. Nor did she have an affluent family to fall back upon. In her world, college was the surest path to success and stability. So, when she decided that she would drop out of college for the job, it appeared like a very risky call that could backfire with disastrous results.

The gamble paid off. She was offered a salaried job at the corporate headquarters and became an executive vice-president by the time she was 26. At the age of 32, she was hired by Cinnabon (of Focus Brands).

Many would consider dropping out of college to be risky. This is why context is important. Kat’s father was an alcoholic, while her mother had to work multiple jobs just to make ends meet. From the age of nine, Kat had to help with the house and also look after her two younger sisters. Now, she was getting the opportunity to travel abroad, and she was excelling and being appreciated for a job she loved.

She was achieving the security and stability she lacked as a child. She was being presented with a way to get what she ultimately wanted, even if it was not on the terms most people would be comfortable with. It seemed a better option to stick on and work her way to an executive job rather than accumulate college debt.

For many, dropping out of college is risky. But here, the alternative was very compelling.

Financial Implication: This is why you should not copy someone else’s portfolio. For example, a particular investor may do well to have a credit fund in his portfolio. But it could be a bad choice for an investor who cannot afford to lose any money.

What you magnify, you obsess over

On March 8, 2014, Malaysia Airlines Flight 370, carrying 227 passengers and 12 crew members, lost contact with air traffic control less than an hour after taking off from Kuala Lumpur. It veered off course and disappeared.

A plane crash is sensational. But the macabre nature of this incident lay in the fact that it did not crash, but vanished into the night.

Think about it. In today’s digital age, we can contact anyone, anywhere, anytime. In fact, to be disconnected, even for a short while, requires a conscious decision and a fair bit of planning. So an aircraft going off the radar was extremely bizarre. The entire world was gripped with this story.

An article in the US media noted that many more individuals died from heart diseases, strokes, cancer, car accidents and murder. But they did not garner as much attention as Flight 370. They did not get remotely as much news coverage.

Threats like plane crashes, which are statistically insignificant and not frequent, grab our attention and scare us more than those that are deadly serious, but common.

When 9/11 was still afresh in people’s memories, more Americans avoided planes and preferred driving, though the latter is much more dangerous. The memory of the recent catastrophe made the fear of flying weigh more heavily than it rationally should have done.

This is recency bias at play. We tend to look at certain things as risky, when they are not.

Financial Implication: When the market crashes, we immediately want to pull out of equity. A company earns bad in a quarter and we want to sell the stock. Something is always going on when it comes to geo-politics. All these are out of our control. Yet, we habitually ignore the slow-burning risks where we do exert influence: how much we save versus spend, how we have allocated your portfolio, whether we’ve built an emergency fund, and so on.

The author is an Investment Specialist at Morningstar India

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