Step 2: Required risk consumption
This is where personal goals come in relative to risk. The idea of required risk consumption is based in the law that anything with potential benefit has risk. Further, there’s often a correlation where the higher the benefit, the higher the risk. So if you want huge benefits, then the required risk consumption is likely to be much higher than if you only wanted small benefits.
This is, on an oversimplified level, the difference between getting what you want and not getting what you want. If you want something badly enough, then you accept the required risk consumption and use the remaining steps to navigate and mitigate risk where you can. If your risk tolerance is hard-wired but doesn’t cover the required risk consumption of your goals, you must change your goals.
For some, this is a freeing notion. When you alter your choices to match other priorities, in this case your risk tolerance and capacity, you can gain a sense of peace.
For others, this is a signal to change their risk tolerance or find ways to increase their risk capacity.
Combining the first two steps – risk tolerance, capacity, and required consumption – gives you a picture of your goals from a risk perspective.
Step 3: Risk policy
The idea of a risk policy is to help guide your own actions and the actions of others who do work on your behalf. Ray Dalio, founder of hedge fund Bridgewater, talked at length about getting the right kinds of actions through the right ‘policy’ foundations in his book Principles.
When creating risk policy, note it has to be customized to what you do. For example, Dr. Rosen’s company d1g1t is in the financial analytics and wealth management space, so risk policy would be things like the kinds of accounts and investments work for clients. In other industries, such as sports, for example, risk policy might be more focused on injury prevention and optimizing technique.
Think specifically of your goals and tolerance/capacity when creating mandates. In general, think of policies or mandates that help you:
- Capitalize on growth opportunities
- Keep you on track toward your goal
- Minimize loss
- Help you automate decision making (e.g. decision-tree frameworks or escalation pathways)