A Simple Rule for Risk Assessment

So much of life boils down to the simple idea of risk. Every choice we make has some chance of a negative result, and being able to assess the chances of that negative result helps us figure out which choice to make.

In day to day life, we make tons of quick risk assessments all the time. Jumping down from this ledge is too risky. Speeding a little is worth the risk, but speeding a lot is not worth that added risk. Is it worth the risk to our friendship to tell my friend what I really think?

However, the more complicated the situation, the worse we tend to get at such quick risk assessments, but we still rely on them far too often.

Is the risk of this car loan worth it in order to get that shiny new car?

What about the risks associated with buying this not-really-necessary item and raising our credit card balance?

Should we put our money into stocks or leave it in a savings account?

So often, the reader mailbag questions I get boil down to a simple question of risk assessment. A person is having a hard time determining which path in their life is more risky and they’re asking for my input.

In the end, what I usually do is put myself in their shoes and use the same simple rule for risk assessment that I use for myself when I’m unsure of a situation.

Here’s that rule. Whenever you’re thinking of taking some significant risk, ask yourself this simple question: is the worst (reasonable) case scenario tolerable for me? If it isn’t, find a more conservative option. If it is tolerable, then that risk is acceptable.

Of course, actually knowing what that worst case scenario is and how likely it is requires some research in most cases.

For example, if you’re trying to make a decision about an investment of some kind, it’s good to know the history of such an investment and the history of such similar investments. This way, you can understand what the worst historical scenario is, and I usually assume that the worst case scenario for me is about 10% worse than the worst historical period of the same length.

Another example: if you’re trying to make a decision about life insurance, imagine that you pass away two days after getting the insurance. What happens to your family in that case? Is the money you’re leaving behind via the insurance and your estate enough to cover their needs with some room to breathe?

I’ll give you a third example from my own life. My wife and I have been struggling with various health care options as she returns to work, since she has something of an open enrollment period now. One of my assessments of the options – perhaps the most important assessment – was a scenario in which one of the members of our family had a very long illness, such as cancer, that required extensive care. What would happen to us under each health care plan? Would we be able to survive? We eventually chose a plan that offered a high deductible for individual treatments, but great coverage for such long-term illnesses, as that plan offered a benefits package that matched what we could do for ourselves financially.

The worst case scenario is a spectacular guide for every major financial decision you need to make in your life. What happens to you in that worst case scenario? Is it something you can financially live with or not?

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