By Travis J. McShane, CFP, CFA

These two words are foundational in the world of finance, but without any additional context they can be difficult concepts to grasp.

-          What does “risk” mean as it relates to your finances?

-          What is an appropriate “return” for a given level of “risk”?

We already subconsciously make dozens of risk/return decisions each day:

-          Have you ever driven faster than the speed limit?

-          Have you ever flown on an airplane?

-          Have you ever crossed a busy street without bothering to use the crosswalk?

These types of instinctual decisions work well day to day as the risks tend to be minor (if you are being careful) and the rewards are generally minor as well (a bit of time savings or less energy being expended).

When we face larger life decisions with more consequential outcomes, it is usually a good idea to slow down and apply a more rigorous thought process before deciding on a course of action.

-          Should I take a position with XYZ company?

-          Should we move out of state?

-          Should I get married to this person?

-          Should we move Mom into a care home?

For these decisions, we rely on the counsel of close friends and family to help us sort through the pros and cons and make sure we do not have any blind spots. The Book of Proverbs frames it this way: “Without counsel, plans go awry, but in the multitude of counselors they are established.”

Next, we arrive at problems that cause us to seek out expertise beyond our immediate friends and family. Being a millennial, this usually starts with me poking around the internet to see if I can find an article or two to answer my specific question or, even better, a how-to video on YouTube. This method is hit-or-miss, and the critical skill here is identifying credible sources to help with your problem. Equally important is knowing when you are out over your skis. Here are a few areas to tread lightly if you face more than basic issues:

-          Doing your own electrical repairs (you turned off the breaker, right?)

-          Doing your own plumbing repairs (water inside the house, what could go wrong?)

-          Diagnosing your own medical conditions (WebMD search “intermittent chest pain”)

-          Drafting your own legal documents (LegalZoom is the same as a lawyer, right?)

The common characteristic in each of these scenarios is the magnitude of the negative outcomes if things go bad. If things go well then great, we just saved a few bucks and handled our problem. However, if things go bad, then it usually ends up costing us a lot more than if we sought out some professional help initially. Also, there is that ever-present feeling of “did I do that right?” that sticks with you for a while even after the job is done.

When we are finally ready to hire help, it is usually because we want the job done right by a person who has done it more than a few times before, and we want to trust in their expertise to help navigate the situation we are facing. If you’ve ever hired a trusted professional before for something that is giving you anxiety, then you are familiar with the accompanying sense of relief knowing that your problem is being taken care of. One of the biggest things that separates professionals from amateurs is the critical element of “practice.” Repetition after repetition over years of service allows them to see what works, what doesn’t, and the best way to proceed for a given situation.

Pivoting back to the world of finance, we can delve into some of the context that can be acquired over time related to risk and return.  One of the most common goals we see is: “How can I save and invest my money so that I can maintain a certain lifestyle without running out of money before I die?” Within this simple question are some complex issues that we must face. Here is a sampling:

Personal Factors:

1.)    How much does it cost to maintain the lifestyle you want?

2.)    How aggressively are you saving currently?

3.)    How long do you think you will live? Your spouse?

4.)    Are there other sources of retirement income available? (i.e. pensions/Social Security)

5.)    When do you want to retire?

6.)    Should I save more/less?

7.)    Should I be more/less aggressive with my investments?

8.)    Are there any medical issues to plan for?

Economic Factors

1.)    How will inflation/deflation affect you over the course of your retirement?

2.)    How much will your investments return if they are invested in a particular way?

3.)    How will income taxes affect you during retirement?

4.)    What level of growth is reasonable to expect over my time horizon?

Another important question is “how much weight should I place on any one of these factors?” or “what should I prioritize first, second, and third?” The chart by JP Morgan below helps provide a framework for some of the items we can control.

The saving vs. spending decision is unique to each of us, and we all have many examples of people in our lives at one extreme or the other. The asset allocation and location decision is one way we help our clients with on a daily basis, so we get a lot of practice there.

In general, we can classify most investments in one of the five categories below:

1.)    Cash

2.)    Fixed Income (Bonds)

3.)    Equity (Stocks)

4.)    Real Estate (Rental Properties, REITs, etc.)

5.)    Other (Gold, Commodities, Derivatives, Timber, etc.)

As we work with clients, we need to have a clear understanding of their set of life circumstances so that we can develop a plan for investing their life savings. While I was training for the CFA Charter, a key construct in the curriculum was to make sure to develop an investment policy statement for each client that addresses the following:

1.)    Risk – What is an appropriate level of risk?

2.)    Return – What is my required rate of return?

3.)    Time Horizon – How long is the period I’m investing money for?

4.)    Taxes – What are the tax implications for the particular accounts I have?

5.)    Liquidity Need – How much cash do I need available and at what times?

6.)    Legal Limitations – Do I have limitations on what I can own?

7.)    Unique Factors – Is there anything unique I want to own or absolutely want to avoid?

This is a great starting point to begin to think through how to save/invest. With a plan in place, the next step would be to select investments, implement, and monitor their performance over the years in the dynamic, ever-changing world we live in.

There is no shortage of information available about the financial markets and impromptu advice on what you should be doing. Just turn on CNBC for an hour and they’ll let you know what the latest “Smart Money” is doing that day. I will always caution to slow down when making decisions on how you invest your hard-earned money. Applying a framework, seeking counsel, and remaining disciplined over time are all markers of individuals that are successful in navigating the financial markets in pursuit of their goals.