When it comes to the financial world, the ideal is to succeed. But sometimes navigating your way through the financial world can be like walking on a tightrope, with a very thin line between failure and success. And like walking along the tightrope, your chances of success are affected by the levels of risk involved in every stage of the game. But what does risk really mean in the world of personal finance, and how easy is it to understand?
In terms of investments, the way that risk is presented often affects the way it is perceived. For example, when preparing financial plans, I look at the client's chances of success (i.e., dying with an estate worth X amount). If the chances of success are low, I look at factors that the client can control in order to increase his chances (i.e., increasing savings, decreasing spending, retiring later, etc.). If the plan shows high chances of success, I look at the factors that could be changed in order to improve the person's current lifestyle without harming anticipated future success.
What is a "high" or "low" chance of success? Unfortunately, there is no magic number. People's judgments about risk are subjective. One 50-year-old might be satisfied with hearing that he has an 80% chance of success, while another person might not sleep well at night until his odds of success have increased.
Which is riskier?
If I tell someone that he has an 80% chance of meeting his retirement goals, it may sound pretty encouraging. In fact, clients are frequently happy to continue with that status quo. However, in "real" terms, 80% translates to one in five people in similar situations where the clients outlive their money. I certainly wouldn't want to be that one!
People may not be enthusiastic about receiving 5% returns when inflation is 3%. But the same investor may be happy to get a 7% return when inflation is 5%. While both are receiving the same 2% real return, the second scenario seems like a better deal because the numbers are higher.
Don't let numbers lie
Don't be lured into a false sense of complacency just because a statistical simulation gives you X% chance of success in your financial plan. Think about the number that you feel you need to achieve in terms of odds of success. Before you accept a percentage of chance of success, ask yourself if this grade is really appropriate in your particular case. Remember - even if the market fluctuates, you play a large part in determining your financial success.