“…I think of [risk] as a mathematical equation…Threats x Vulnerabilities = Risk.”
― Stanley McChrystal, Retired United States Army General1

What is risk, and how do we manage it?

These are age-old questions when it comes to both investing and life. This is particularly the case today when we have a new and unpredictable war to contend with in Eastern Europe, lingering pandemic concerns, cybersecurity threats, and 40-year highs in inflation.

In its simplest terms, we usually define risk in our daily lives as the possibility of something bad happening, such as loss or injury. When it comes to investing, risk is often measured in much more complex ways.

The problem with most definitions of risk is that they don’t provide a practical road map for you to manage and address risk in real time.

There is another definition of risk that I heard on a podcast recently that caught my attention because of its potential practical applications:

Threats x Vulnerabilities = Risk2

Threats can be thought of as events that are largely out of your control — for example:

  • unexpected tragedies (pandemics, terror attacks, hurricanes, and other major weather events)
  • geopolitical crises (wars in Russia/Ukraine, corrupt governments)
  • financial shocks (inflation spikes, the financial crisis of 2008-09, Brexit, the dotcom bubble bursting, the “Black Monday” stock market crash of 1987)

Vulnerabilities, on the other hand, are things over which you may have some control, such as:

  • living beyond your means
  • not having enough emergency cash reserves
  • making concentrated investment bets (individual stocks, sectors, or countries)
  • taking greater investment risk then you can stick with over time

Ignore the Threats and Address the Vulnerabilities

The best thing we can do in times of uncertainty is to focus on what we can control, and that is our financial vulnerabilities. An important question to ask yourself is what vulnerabilities listed above could be addressed or updated to help reduce risk for you and your loved ones?

Using investing as a practical use case and the chart below, it is easy to see how threats over time have led to periods of significant financial market volatility. While this can be quite unnerving in the shorter term, a globally diversified portfolio that is managed with a long-term, goal-oriented perspective can make it easier to navigate short-term choppy waters.

The example shows how $1 invested in 1970 in the globally diversified MSCI World Index has since grown to $983, and that was despite many global threats along the way, which are highlighted in the chart. Add a few zeros, and we could also say that if you invested $10,000 in 1970 in the MSCI World Index, you would have amassed around $980,000 today — even though a lot of stressful and uncontrollable events happened during this period.

Graph shows an overall rise from $1-$98 in Growth of a Dollar - MSCI World Index (net dividends), 1970-2021

Be a Stoic

I am a fan of author Ryan Holiday and his writings on Stoicism. He wrote, “The single most important practice in Stoic philosophy is differentiating between what we can change and what we can’t”.  Taking the Stoic approach to portfolio management requires you to concentrate on minimizing your vulnerabilities.  Good examples are the following:

  • Developing an allocation that supports what you are trying to achieve
  • Broadly diversifying your holdings
  • Utilizing low-cost investment solutions
  • Keeping an eye toward taxes

While none of these tactics will help you avoid the temporary impact of a threat, they can help to reduce your long-term vulnerabilities.

To learn more about minimizing your financial vulnerabilities, please get in touch with us.

 

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