Risk is a tricky word to pin down. Some people might say “riding a bicycle on the road is too risky” or “I only have a cash ISA because shares are too risky”. Others will think those views are silly.
There isn’t a clear line between risky and acceptable. It’s a personal question of what you feel able to tolerate.
When it comes to investing, people fixate on the risks of the stock market:
- What if the market crashes?
- Will I get the return I expected?
- How much can I draw down from investments each year without running out of money?
Those are all valid concerns. But they are far from the only risks out there.
What’s more, if you spend too much time focusing on just one risk then you are liable to make poor decisions.
As The Investor wrote years ago in The first law of thermodynamics and investing risk:
“Investing risk cannot be created or destroyed. It can only be transformed from one form of risk to another.”
So what’s risky for you? That’s for you to decide.
Risky business
Many kinds of risks are familiar both to bankers and to freelance writers penning personal finance articles.
The risk of not getting paid, for instance.
But there are also more specialist ones from the world of finance that are worth us thinking about. These include:
- Market risk – the possibility that you don’t get the returns you were expecting, whether due to performance, interest rates, currencies, or commodity swings
- Credit or counterparty risk – someone else can’t pay you back
- Liquidity risk – when you can’t buy and sell assets as quickly as you’d like
- Operational risk – what happens if the day-to-day running of your business stops working properly?
These map quite easily across to personal finance:
- Market risk – when you don’t get the returns you were expecting
- Credit or counterparty risk – if the bank or broker you’re using goes bust, are you covered?
- Liquidity risk – relying on antique coins for emergencies? They might take a while to convert to cash
- Operational risk – what if you accidentally sell your entire portfolio when you’re half-asleep, swiping on your phone, or you lose your passwords?
These risks all sound clear enough, at least in theory. But other risks are more subtle.
With enough risks, no target is high enough
Maisie wants to retire early. She already has £1,000,000 in her stocks and shares ISA – invested in a global shares ETF – and her budgeting software informs her she spends £30,000 per year.
After Maisie reads The Accumulator’s musings about the UK safe withdrawal rate, she realises that she can retire immediately, withdrawing 3.1% of her portfolio each year.
Great stuff!
But then Maisie tells some folk about her excitement on the Internet.
“Ah,” says EternalPessimist28, “but what if you live for another 50 years? You’ll need a bigger portfolio.”
“And what if you need a care home?” interjects LondonStockBroker. “You should be modelling for £100,000 spending per year after turning 80 to cover that.”
Maisie sighs deeply, and goes back to work for another decade.
Finding the balance
From a purely financial perspective, putting more years in might be the right move for Maisie.
But life is about more than just finances.
What if in the following decade, Maisie’s partner passes away? Or she develops a health condition related to her stressful job?
Clearly it’s not a good idea to retire without enough money invested. But waiting until you’ve minimised market-related risks could well increase your exposure to these other kinds of risks.
A little list of risks
Let’s dive into a few of these less commonly discussed uncertainties.
| Risk Type | What is it? | How to mitigate |
| Sequence of returns | Once you stop earning, multiple years of negative returns can hammer your portfolio’s value | Build up a bigger pot, withdraw less, or return to work. Take steps before it happens |
| Cognitive decline | If your mental capacity starts to decline, you could make poor decisions or fall victim to a scam | Work with a financial advisor, explore annuities, and set up power of attorney before you need it |
| Sentimentality / rigidity | Hanging onto strategies that worked before in the hope that they’ll work again or continue to work forever. For example, waiting for a new NFT boom | Maintaining an open mind and re-evaluating your strategies and performance every so often, or paying for advice |
| Longevity | Planning your retirement funds on the assumption that you’ll die by a specific date | Remember that life expectancy is heavily impacted by your current age. Plan to last for more years than average |
| Forced early retirement | Your health might force you to retire early, or a redundancy later in your career could prove hard to come back from | Consider critical illness and income protection insurance. Don’t rely on your salary continuing indefinitely |
| Family | Principally divorce, but could also include caring for and supporting children more than expected, which could increase costs and reduce capital | Don’t lecture your other half about types of risk. Buy them something nice |
| One more year syndrome | If you get completely obsessed about mitigating risk, then you’ll never retire | Try not to worry so much |
It’s worth taking the time to write out all of the risks that might impact you.
Are you weighting all of them in the same way? Are there others that you’ve forgotten about, or that you’ve deliberately swept under the carpet because they’re too painful to think about?
Or is there perhaps a risk that keeps you awake at night, when it’s really no more threatening than the other risks on your list?
Risk is not all the same
I find it crazy how some people dedicate most of their financial planning to market risk, and then barely give any thought to issues such as longevity, life insurance, or how much they should trust their broker.
You’ll read personal essays going into thousands of words about how somebody plans to minimise the risk of withdrawing too much from their portfolio – adjusting based on various market signals and statistics.
But then a day later the same author will confidently assert that everyone should invest 100% of their portfolio into equities and that nobody needs an Independent Financial Adviser (IFA).
That’s not to say that you can’t invest 100% of your wealth in equities, or that you need an IFA.
You do you.
Rather, the point is that people can get hyper-fixated on certain specific risks, which sometimes seems to crowd out the attention they might give to others.
Rushing roulette
Consider somebody who focuses every day on maximising the amount they put into their ISAs, but who suffers a serious injury and has to quit work. They will surely regret having skipped income protection insurance in order to slip an extra £50 into the ISA each month.
Or take someone who strips their expenditure back to the absolute bone so they can retire in a decade, when they plan to withdraw just 2% of their portfolio each year.
In theory they’ve put their finances on a solid track to FIRE. But if their spouse and kids hate living on Pot Noodles and wearing clothes from Oxfam, the retirement plan may collapse after a couple of years as divorce looms.
Alternatively, you might deal with one risk and forget about all the others.
I once spoke to an underwater welder who told me they didn’t need a retirement plan because they were almost guaranteed to die on the job.
I guess that’s one approach to longevity risk.
Early retirement remains an option
Personally, with each year that passes I am less worried about stock market risk.
That’s not to say that I don’t care about my investing returns or the next bear market. Of course I do.
The problem is that if that’s my only concern, then I’m leading myself down a path of wanting to save not 25 times my annual spending to retire, as per the famous 4% rule, but perhaps 33 or even 40 times that amount to feel more secure.
These days I’m more concerned about the opposite danger:
- What if I wait until I’m 58 to retire, and then find my health is completely wrecked?
- What if I miss the next decade of my children growing up whilst I’m in the office?
- What if I drop dead before I hit my number?
Sure, we all have to accept there are risks in life.
But if you’re striving to stash enough in investments to take a punt at early retirement, then you might try to mitigate the worst of these other risks too.
For example, if I’ve hit the point where my annual spending is equivalent to 4% of my assets and yet I choose to delay retiring for another five years to bring that down to 3%, am I really taking the less risky option?
It all depends what kind of risk I care most about.
One risk to rule them all
You cannot negate every financial risk out there. Instead, you must figure out what most matters to you.
Is it retiring with the (near) certainty that you’ll never run out of money?
Or perhaps you’re less bothered about never needing to work again – rather, you just want to know that you’ve got enough invested to cover the bare essentials if you do lose your job.
Plan accordingly.
Or maybe the objective is to retire quickly, maybe before your kids move out, or whilst you’re still fit enough to hike around the world?
In that case it might be worth modelling a higher withdrawal rate – knowing you might have to go back to work one day – in order to experience your once-in-a-lifetime adventure.
I can’t tell you what retirement target is right for you, how much you need invested, nor the rate you should be withdrawing it at. (Though I know a guy who can help you with that.)
Nor can I tell you that you need to retire at 40, or that you should eat nothing but beans and rice to free up more cash to pay off your mortgage.
I’m just saying don’t lose sight of everything else in your life in pursuing a narrow financial goal.
That seems to me to be the biggest risk of all.
