Will You Risk It For The Biscuit?

We all have different risk tolerances in life. If you like the thrill of investing in cryptocurrency, putting $100 down on the over for the length of the national anthem of the Super Bowl, or even just blowing through a yellow light, you probably have a high risk tolerance. If you’d rather spend an afternoon knitting, buying U.S. Treasury Bonds, or driving the speed limit in a Volvo, you are probably not a risk-taker. Is there a right or wrong way to approach risk in your life? Not necessarily – although being on either end of the risk spectrum would be problematic. When it comes to your finances and career, though, risk tolerance can be both a frequent and important factor in your decision-making. Understanding the risks of any given situation – regardless of your personal risk tolerance – is key to taking the best path forward. Because it is such a big topic, I’m going to do a series focused on risk in both your personal finances and work. This week, I will focus on the concept of risk to set the stage.

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What Is Risk?

Before we jump into how risk plays into your life, it's important to understand the term. Risk is defined by my pals at Merriam Webster as “possibility of loss or injury”. With the hopes that all my readers take proper safety precautions at home and work, let’s focus on the “loss” portion. Losses can come in many different forms – typically arising from a decision point. You can have tangible losses (money, for example) where you may or may not know exactly what you stand to lose. Placing that Super Bowl bet is a clear gain/loss situation, where you either win the bet and get (nearly) double the money you put down, or Post Malone's anthem rendition comes in ten seconds early and you lose all the money. Buying a stock is unlikely to result in losing your entire investment (unless you’re me in 2006!) , but you could certainly lose or gain a percentage of your investment.

You could also have an intangible loss from taking a risk. You could watch that next episode of "Hangin' with Mr. Cooper" instead of getting breakfast with ample time. You choose to find out if Coop makes the Golden State Warriors, assuming you can navigate across town in time for your desired loaded breakfast burrito. Lo and behold, there's a Flag Day parade, causing a 5-minute detour. You arrive at the drive-thru at 10:31, and Hardee's has made the irreversible transition to lunch. Your intangible loss teaches you a valuable lesson: Mark wouldn't have made the Run-TMC Warriors if he was tardy to tryouts!

Opportunity Cost

Sometimes risks can have collateral impacts that indirectly arise from your choices. One of those impacts would be opportunity cost. Think of opportunity cost as the “what if” of the decision-making process. If you choose to A instead of B, and A fails, what would you have gained from B? Opportunity cost is a critical consideration in the decision-making process. Say you want to do a bathroom renovation in your home. You get some quotes, and are shocked to learn it will be $35,000 to get the chandelier-over-the-soaking-tub look you want. If you choose to move forward, it would mean pulling the money out of your retirement savings. For simplicity sake, let’s pretend you can’t refinance your house, borrow money from your ex, or rob a bank. Your opportunity cost would be the potential future gains of your retirement savings. Of course, there would be an opportunity cost of keeping the money in the retirement account… you would be stuck with a lame chandelier-less bathroom!

Knowing Your Options

In any situation, you always have at least two options: do nothing or do something. You will usually have several options, and understanding the risk and reward all of those options will help you make the optimal decision. Oftentimes, we make poor decisions because we either didn’t realize all of the options available or didn’t properly investigate the identified options.

Let’s use the purchase of a car as an example. Buying a new car can arise from simply being ready to find a new vehicle without an particular urgent situation, but many times there’s a driving force that often is time-constrained (car accident or needing costly repairs). In those urgent situations, we are often pressured to make a quick decision without thinking through all options. There are so many car brands and models, it’s not practical to consider all options. Obviously, you’ll want to see and test-drive any car you’d buy, but you won’t have time to get behind the wheel of every possible vehicle. So how do you properly vet all options?

First and foremost, invest an hour or two into doing some internet research. There are dozens of car sites that will help you pick the right vehicle for you based on cost, size/model, new/used, features, etc. Once you’ve gotten a feel for what fits in your price range, spend some time researching reviews from an independent review site (one not trying to sell you a car!) so you get some additional insights. Once you have a couple of options in mind, do another search for these vehicles for sale in your local market. Identify specific cars and then invest the time at the dealership (or private seller) to look at and drive it in person. Consider all trade-offs (cost, mileage, even the color and cup-holder count!) before buying. This may all seem like a lot, but a purchase as major as a vehicle should require some effort upfront. Compare this to deciding what to order for dinner at your favorite restaurant. You will hopefully eat again within 24 hours, so don’t stress over these frequent decisions!

So now that we are risk experts, let's tackle risk in our personal finances. Not now, next week. Enjoy your weekend!