HOW TO MEASURE RISK
As I fly to my mother in laws funeral, I’m overcome with the riskiness of life. It’s not that Ruth went before her time, on the contrary she died at age 90 after a full life. She raised 2 successful sons, was married to the love of her life for 67 years, and died in the same home in which she, her brother, and her children all grew up.
Yet, even though we knew Ruth would pass, it came as a shock when the phone rang at 4:30 AM the other morning. I was overcome with feelilng and reminded of the uncertainty of life.
Now, I’m a planner and come from a planner. My mom has already prepaid my dad and her funeral expenses. She has all the details laid out. She inquires months in advance when I can visit and when can she come to stay with us. She and my dad had appropriate insurance for all eventualities which came in handy when they were sued one time.
Yet with all the insurance and planning in the world, one cannot avoid risk. Actually, if we thought about all the risks we encounter every day, we would probably stay in bed and never leave. Of course the recent devastation of Hurricane Sandy is yet another reminder of our lack of control.
Throughout the Investments Class I teach to MBA students, the underlying theme is balancing risk management with wealth building through investing. Yet, look back on the mortgage debt crisis of 2007-2008, or the dot com bubble bursting the beginning of this century any investor knows risky drops in the stock market are inevitable.
So how does one measure and protect against risk?
Risks in Investing and Wealth Building:
Which of these risks keep you up at night?
- That your investment portfolio will decline in value
- That your investments won’t increase your wealth as much as expected or planned
- That your wealth building strategies fail
- That you’ll lose your job
- That your entrepreneurial venture will fail
- That you fail to save enough for retirement
- That you’ll never pay off your credit card debt and start building wealth
How to Measure Risk
The best and yet albeit imperfect method of measuring risk is to look to history. What was the greatest stock market decline in one year? How likely is it that someone in my industry and position will lose their job? How much money will I realistically need to live in retirement? And will the historical 3% inflation rate continue in the future?
History may or may not repeat itself, but the last time I checked, it’s fairly difficult to predict the future. So if you want to measure risk and prepare as much as possible, use history as a guide and then be a bit more conservative and look at some worse case scenarios.
Stocks, bonds, and cash are all risky investments. Historically, stocks gained an average of 7+% over the last 100 years or so. Bonds gained about 5% and cash about 3%. All looks great, but…… underneath those rosy averages are decades (like the first one of this century) where stocks barely increased at all. And right now cash is not paying a return. Factor in inflation and you’re losing money on your cash.
Asset Allocation means so when one investment goes down, the others will cushion the blow and your entire portfolio will be less volatile.
Automatic saving into your desired asset allocation means that when investing in stock investments, you’ll buy more shares when prices are low and less when they’re high. The sooner you begin, the sooner your portfolio will benefit from the compounding of your returns. Simply put, compounding means that your money is building on the money you already have.
These two investment strategies won’t guarantee that you won’t have a losing year once in awhile, but will help cushion the ups and downs. It will also help you grow your wealth long term.
Education is like the asset allocation of employment. The more you grow your skill base, the greater your importance to your company and employer. There’s also data from the bureau of labor statistics which shows that more education is correlated with higher income and less unemployment.
Creating additional income streams cushions against the possibility of unemployment. If one income stream dries up, you have other’s to rely on. Shwanda, a close friend has a salaried job with a university, book royalty and consulting income. Although her main income is from her university job, if that income dries up, she still has other monies coming in.
Retirement risk is very real as many 40-50 year olds are staring retirement down with little savings, too much debt, and worries about social security. Start saving and investing now. Even if you have little saved now, it is not too late. Get rid of your debt. And confront yourself and your lifestyle decisions. Look into alternate income streams for retirement. Examine your lifestyle decisions and determine whether they are sustainable or not. Confront your future, avoiding will only make it worse. And if you can’t do it on your own, see a money counselor, life coach, or therapist to help you along.
Without money for the future, you will be dependent upon the government and loved ones for your support. Is that how you want to spend your later years?
How do you prepare for the risks in your life?
image credit; google images-CNN Money