Let’s really talk about risks

October 27, 2016
Woke Money
There is always risk involved. You can't be a capitalist only when there are investment profits but then a socialist when you experience losses. 
-Cristina Kirchner

Only focusing on being “debt free” and having an “emergency fund” is like claiming that your favorite team won on defense alone, not needing any offense. 

 

(we are not talking about that kind of risk!)

Comprehensive financial planning uses cash management, debt, tax-planning, investing and insurance so you use all resources in the best way over time. 

In terms of a holistic plan, amassing cash is incomplete planning.  It deals very well with market risk, the volatility of the stock market (or any other capital market).  But it gets a zero in terms of dealing with the inflation rate risk (see notes risks below).  The after-tax return on cash is lower than the rate of inflation. 

What if you take a bit more risk and put money in bonds.  Now you added volatility risk and interest rate risk, but did dampen your inflation risk.  Next, you could add stocks.  Now you really addressed inflation well, but you also ramped up your volatility and increased your liquidity risk.  You will need to diversify the stocks and the bonds, - you can’t just buy Apple stock or a short-term bond fund.  Yes, there is so much planning to do.

A good plan will design your cash management, debt and investment strategies based on your goals.  If you can fund all your goals, you need less return and can take less risk.  If you are far from your goals, you need to judiciously take on more risk. 

Okay, then, what if you need an enormous risk to reach your goals?  You can’t fully amp your investments without going so far beyond your risk tolerance so that you can’t sleep at night.  It would be better to take the goals down a notch.

Good planning

You need to cost out all your goals, then compare those costs to your resources to use them in the best way to achieve those goals.  And at the end of any plan, this caution should be added: 

The single most important risk to planning is a poorly defined or constantly changing strategy.  You must have a long-term approach to which you adhere over time regardless of the current favor of the particular strategy.  That will work, while chasing constantly changing tactics will not.  P.S. - adhering includes monitoring and managing, as forgetting about it may not work well. 

So, evaluate  the risks that match your goals so you can plan well! 

 

Notes on risk:

1.  Specific and Non-specific market risk - are buying a single stock versus buying the entire market.  You address these with diversification (cross-correlations among major asset types reduces volatility over the long-term without reducing returns) and asset allocation.

2.  Interest Rate Risk - is the inverse relation between the direction of interest rates and the value of a fixed-income asset as set by the market.

3.  Inflationary Risk - is the erosion of returns in terms of purchasing power due to inflation.

4.  Opportunity Cost Risk - is the failure to invest in assets producing the necessary returns because one chose instead to remain in cash.

5.  Liquidity Risk - is the risk that the investment chosen is one that cannot be liquidated until sale.

 

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