3 WAYS TO PROTECT YOURSELF FROM FINANCIAL RISK

By in Asset Allocation, Automatic Saving, Investing | 9 comments

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.

financial risk

risk

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.

  1. Investing Risk

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.

To guard against the risk of investing, there are two solutions; Asset Allocation and automatic saving.

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.

  1. Career Risk

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.

  1. Retirement Risk

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

 

    9 Comments

  1. Excellent post and please accept my condolences on your loss.

    Too many investors focus only on the upside potential of their holdings. Sadly these investors often learn about the importance of risk control by painful experience.

    Roger Wohlner

    November 11, 2012

  2. Very helpful enumeration of risks in order to arrive with realistic and more precise estimations. I guess it’s a matter of balancing advantage vs. risks. Some established trends and less risk but sure-win arrangements are good priorities.

    Amy @ JobCred CV Builder

    November 11, 2012

  3. I think we all assess risk differently. For example, I accept volatility in my investments because I am willing to take on more risk. Most (maybe all)of my basic expenses of retirement are covered by Social Security and a pension. In other words, my necessities are covered and my wants are satisfied by my investments.

    krantcents

    November 11, 2012

  4. Awesome post! I am also sorry to hear of your loss. I am a planner as well, so I do my homework and try to prepare ourselves appropriately. No one is immune to risk, but it can be possible to lower its impact.

    John S @ Frugal Rules

    November 12, 2012

  5. @Roger, Amy, Krantc, and John, Thank you for your condolences. I appreciate all of the remarks about risk. It’s so important to be aware of the risks one can control. And when possible understand your potential losses. In fact, experiencing a personal loss, puts the fragility of life into perspective.

    Barb

    November 12, 2012

  6. Sorry about your loss.

    As for risks, there sure are a variety of them, and the reality is that they are a part of life. This include our finances, whether it’s income, investment, or other risks.

    The one that you put in there, which I hope doesn’t get lost, is the 3% inflation rate risk. People aren’t thinking too much about this as of late, and admittedly that includes me. But there have been times with much higher rates of inflation, and a repeat of that can wreak havoc with many a retirement plan and lifestyle. Important to not forget about this risk!

    DPF

    November 18, 2012

  7. @DPF-I totally agree with your remarks that with recent low inflation rates folks tend to forget that the recent past is not indicative of the normal inflation rates. The average historical inflation rates are 3% with highs in the double digits in the late 70’s and early 80’s.

    Barbara Friedberg

    November 19, 2012

  8. I prepare for risk by planning and planning and planning some more.

    Dominique Brown

    November 19, 2012

  9. @Dominique-Yes, that’s my strategy as well. I like the illusion of control!

    Barbara Friedberg

    November 19, 2012

Post a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

WP-SpamFree by Pole Position Marketing