Are you risk literate? And what about your Financial Planner?
Everybody understands the importance of literacy, but risk literacy is a concept that is becoming important in Financial Planning.
Risk literacy is a measure of your ability to make the right decisions when the outcomes are uncertain.
If you are not risk literate, you will find it much more challenging to build up wealth, preserve it, and make it work for you in retirement.
But you aren’t on your own; 76% of Americans don’t know how to express a 1 in 1,000 chance as a percentage!
Now, I think that risk literacy is interesting. It’s the type of maths that people like. It can help you to work out the likely outcomes of drinking, or swimming in shark-infested waters! Or whether you should take your umbrella with you to work (what do those rain percentages mean on the BBC weather website?).
Risk literacy is not a new concept. It’s well known in the medical profession where it has been used to judge risks and inform choices about the future – indeed, risk literacy is even seen as a way of maximising NHS resources, as it means that better health outcomes can be achieved from the same budget.
The risk of death from an activity can be measured in “micromorts”.
One micromort = a one in a million chance of dying. A general anaesthetic carries ten micromorts (i.e. it results in 10 deaths per million operations); one skydive has the same number of micromorts.
Driving a car for 400 kilometres exposes you to one micromort; that’s the same as riding a motorbike for 10 kilometres or flying 10,000 kilometres. No statistics for racing your pushbike!
Research has shown that we are not, on average, risk literate. But the authorities assume we are.
In the medical field, it is assumed that we can make good decisions about the potential outcome of an operation or other medical procedure. But it’s unlikely that we (or the doctor) have the risk literacy skills to make these decisions well.
So, when it comes down to important decisions, we are probably guessing.
In the world of Financial Planning, we ask you to fill in questionnaires about the investment risks you are going to take. And we assume that you have the ability and knowledge to answer all of the questions rationally.
We believe that you were paying attention in your Mathematics lesson on the day you were rolling dice and flipping coins and working out probabilities (and that you can still remember all those formulae). This is why our initial, computer-driven risk assessments need to be followed up by a proper discussion of risk.
In the world of retirement income planning, we now have the equivalent of micromorts – but instead of working out the chances of dying, we can work out the risk that your portfolio will be exhausted before you die. Technology allows us to show you how likely this is.
But we still need the ability to understand these risks, and to make rational decisions.
The same client was delighted to hear that there was an 80% chance that he would outlive his money, but, just a few minutes later, distressed to hear that there was a 20% chance that his retirement savings would be exhausted in his lifetime.
Self-awareness is pretty useful here. Before making critical financial decisions, it can be helpful to know how risk literate we are. If we know that we are likely to make a wrong decision, it’s more likely that we will seek help before making that decision.
The good news is that you can now test your risk literacy score (and, at the same time, help with academic research) in just a couple of minutes by going to riskliteracy.org. Take a look at youtube.com/watch?v=SoTLrfV4Hjs if you want a couple of quick tips to improve your risk literacy (ignore the German title page!).
And, of course, you should ask your adviser how they did in the risk literacy test. There’s no point in asking a risk illiterate adviser to help you make an informed choice!Risk literacy is a measure of your ability to make the right decisions when the outcomes are uncertain Click To Tweet