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How to Think About Risk

Barrington Financial Advisors, Inc.

Here is an article from Motley Fool that I consider very thought provoking. Although we at Barrington can’t plan for every event that the future holds, we do plan for liquidity, flexible in our expectations and the willingness to adapt to changing circumstances. It is therefore very important that we be advised of any changes in your personal circumstances so that we can create a workable solution to your problems.

How to Think About Risk

Morgan Housel / November 5, 2015 / – Commentary

MorganMorgan Housel is Motley Fool One’s expert on the intersection of investing, economics, and human nature. He studies the impact of big-picture issues on individual investors’ lives — making us better Fools along the way.

Context: No investor is an island, and Morgan sets out to help you understand how things outside your control that can affect your financial future.

“Bad weather in the first quarter pushed the U.S. economy into negative territory,” read a headline I saw this spring.

It’s true. February and March were brutally cold and snowy on the East Coast, which kept consumers away from stores, shut down businesses, and brought trucking shipments to a halt.

It had a big impact: The model used by the Bureau of Economic Analysis suggests weather lopped a full percentage point off economic growth from January to March. That’s huge. It could easily be the biggest hit to the economy this year.

But here’s what’s interesting …

Go back a year ago and look at what economists said were the biggest risks to the economy in 2015.

They talked about the Fed raising interest rates. A housing slowdown. A recession in Europe. Greece defaulting on its debt.

No economist, I promise you, mentioned 9 feet of snow in Boston.

They couldn’t have talked about this risk because it was unknowable. No meteorologist, let alone economist, could have known with reasonable certainty that bad weather was about to hit the economy until right before it struck.

That fact alone tells you most of what you need to know about risk.

“Risk is what’s left over after you think you’ve thought of everything else,” writes financial advisor Carl Richards. The biggest risk is always the stuff that no one is talking about because it’s impossible to predict.

The best example of this came 14 years ago. Here’s a news article from September 8, 2001: “[Economists] acknowledged that risks remain, chief among them the continued decline in corporate profits.”

Think about that. Seventy-two hours before the 9/11 terrorist attacks, the top worry on economists’ minds was dwindling corporate profits.

Obviously, no economist could have known that a risk magnitudes greater was hours away. But that’s the point: Risk is what’s left over after you think you’ve thought of everything else.

When I heard about this winter’s impact on GDP, I thought about the thousands of economists — many of them brilliant minds with PhDs — who spent countless hours forecasting what the economy will do this year. Because of some freak snowstorms, every model and prediction they made before three months ago is moot. It’s wrong. It’s basically useless.

That’s not a criticism of economists’ inability to predict bad weather. It’s a criticism of how they — and so many of us — view the value of predictions in a world that is inherently unknowable.

In his book The Black Swan, Nassim Taleb wrote:

The inability to predict outliers implies the inability to predict the course of history … But we act as though we are able to predict historical events, or, even wore, as if we are able to change the course of history. We produce thirty year projections of social security deficits and oil prices without realizing that we cannot even predict these for next summer — our cumulative prediction errors for political and economic events are so monstrous that every time I look at the empirical record I have to pinch myself to verify that I am not dreaming. What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.

What can you do about it?

Here’s Carl Richards again: “Our assumptions about the future are almost always wrong. We can never think of everything — but we can take sensible steps to protect ourselves from life’s inevitable surprises.” For most of us, that means having a lot of liquid savings, flexible expectations, and the willingness to adapt to new circumstances. Just like evolution, the key to survival isn’t being strong; it’s being able to adapt to whatever is thrown your way.

“At its best, life is completely unpredictable,” said Christopher Walken. And at worst, you’re totally unprepared for it.