Risk Management is sometimes an intimidating topic that can easily become confusing and tedious. Let me try to make it easy to understand and maybe even fun too!
Let's start with a story....
It's late at night. You hear your trash can fall over behind the garage. You want to peek out of the kitchen window.
What will you see? A burglar? What do I do? Where's my cell phone? Are the doors locked? Why didn't the motion detector on the floodlight go on?
So you peek out of the window and you see Jack, the neighbor's tabby cat looking for scraps! You forgot to put the lid on the can. You breathe a sigh of relief! A cat made my adrenalin flow! Now that I know the risk I am dealing with (cat vs burglar), I now can decide what to do next. So you go outside and the light does turn on and you secure the garbage can with the lid.
So what can we learn from the cat? Well, once you define the risk, you can deal with the risk. Most of us worry too much because we have not taken the time to define the risks in our lives so we don't know what to do. So make a point of doing some homework. You will be surprised at how much worry you can eliminate just by knowing exactly what is actually involved in our day-to-day risks.
Risk is something that we are managing all the time. When we get into our car, we put our seat belt on, adjust the mirrors, and follow the "rules of the road" always looking to for the crazy driver in our rear view mirror. When we gas up the car, we check the tires and sometimes we might check the oil and fluid levels. Why? Because we know that these measures reduce the risk of accident or road-side breakdown.
And if we have children, we multiply this by 10! We are always looking for what could injure our precious bundles of "out-of-control" joy!
We can respond to risk in these 4 ways below if we take driving a car as an example:
So the first thing on developing a risk management strategy is to properly DEFINE the risk first and then decide to avoid | manage | transfer accept it. If you get that wrong it is unlikely you will find a solution that will work.
See if this makes sense to you. In order of frequency, you | get sick | incur an injury | have a fender-bender | have an operation in the hospital | become disabled and cannot work for a period of time | require long term care | have a heart attack | die. But chances are that all of these things will not happen to you. You just might avoid most of this, and live to be over 90 years old.
There are various types of insurance policies (health | auto homeowners | disability | long term care | life) that can cover the expenses incurred because of a lifetime event. You can also reduce risk by modifying your behavior. You can eat nutritious food, exercise, involve yourself with activities that stimulate your brain, and find companionship so that you are not alone without help. As you get older, you can downsize to a single level dwelling, secure the rugs, and place hand railings where you need them.
Portfolio managers and raving analytical people (like me) obsess with defining and managing investment risk to protect portfolio assets. Here is a detailed list of what is involved here. The purpose of sharing this with you is NOT for you to learn all this but to appreciate and be working with a designated professional who will do this for your investment portfolio. Most financial advisors have a team of investment management firms that specialize in risk management analysis. Think of it as the "insurance policy" that is protecting your portfolio.
Systematic risk is composed of risk types that reflect broad economic activity, are market related, and affect all similar types of investments. These risks cannot be eliminated within their own asset class and therefore are said to be non-diversifiable. It is non-diversifiable in that adding more issues to a certain asset class cannot diversify away that risk.
For example, adding 10 more bonds to a portfolio of, say, 20 bonds will not diversify away interest rate risk or purchasing power risk (explained below). However, within the context of a portfolio, those risks can be mitigated with the addition of different assets.
To take a second example, if the 20-bond portfolio is changed to a portfolio of 50% bonds and 50% stocks, the portfolio’s purchasing power risk can be lessened because, over time, stocks outperform inflation. Systematic risk includes the following types, and can be remembered with the acronym
“PRIME”: Purchasing power risk | Reinvestment risk | Interest rate risk | Market risk | Exchange rate risk
Purchasing power risk: Return may not keep pace with inflation.
Reinvestment risk: Dividends produced may not earn as high a rate
Interest rate risk: Bond values drop as interest rates increase. Longer bond maturities and lower coupon rates change the NAV in response to changing interest rates.
Market risk: Securities tend to rise and fall in unison.
Exchange rate risk: Currency values can have an adverse affect on the value between U.S. and foreign currencies. A weak U.S. dollar benefits U.S. investors who own foreign securities.
Unsystematic risk, also called diversifiable risk, describes risk factors specific to an individual investment. Factors such as a company’s management (both ability and creditability), financial structure, earning power, fundamental business plan, patents, product line, position within its industry, and marketing strengths are just some of the specific aspects that can impact the risk of an investment.
It is called diversifiable risk because these risks can be diversified away in a portfolio of several different stocks in several different industries. Unsystematic risks include the following types; it is especially important to understand business and financial risk.
Business risk: Company management, product line, marketing ability, earnings, dividends, and other factors specific to that company or industry contribute to business risk.
Financial risk: Businesses financing using stock (equity) has no financial risk. Businesses financing using loans (debt) has financial risk.
Default risk: Defaulting on company bonds, commercial paper, leases, and loans
Credit risk: A company’s default risk is reflected in its credit rating
Political risk.: Unstable political, economic, or social structure of a country can lead to the manifested in the expropriation of assets, exchange control laws, the overthrow of governments, war, corruption, and riots. Funds tend to flow into the United States as a safe haven for wealth.
Liquidity and marketability risk:
Liquidity is measured by how quickly asset principal can be converted to cash. The less liquidity an investment has, the more liquidity risk it has. Liquidity and “marketability” are frequently used synonymously but does not necessarily imply investors would have difficulty obtaining their money. Mutual funds and stocks listed on the New York Stock Exchange are considered very liquid. Office building are illiquid.
Call risk: Call risk is the possibility that a debt security will be called in by its issuer prior to maturity. Call risk increases when interest rates decline.
Event risk.: Event risk (mostly bonds) can be triggered by an unanticipated and damaging event. The event may take the form of a major tax or regulatory change; a change in a company’s capital structure due to a merger or buyout; disclosure of fraud or other significant misdeeds; negative media attention to a particular product; or a major, unexpected event.
Municipal bonds can experience event risk as well. For example, in 1993 and 1994 the treasurer of Orange County*, California, invested in derivative securities, which eventually caused large, unexpected losses. This, in turn, caused a large selloff of the county’s bonds due to serious questions about the county’s ability to pay back the losses -the county declared bankruptcy on December 6, 1994, due to $1.7 billion of losses from these derivatives.
Tax risk: The misinterpretation of tax laws and regulations for tax strategies or derivatives can place the investor at risk to back taxes, interest and penalties.
Investment manager risk: Investment managers of mutual funds, separately managed accounts and hedge funds may underperform the market.
Fraud risk: such as the Bernard Madoff “Ponzi” scheme gets its name from Charles Ponzi, who offered investors unrealistic high returns and accomplished this by paying off old investors (and himself) with money coming in from new investors. Unfortunately, there have been numerous scams that have come to light recently, and this has given the financial services industry a black eye. This has raised concerns by many individuals whether there is adequate regulation and protection for investors.
So how do we apply all this book knowlege to our lives. Well let's take life insurance and show you how you can figure out how much you need and what kind to get. There are four(4) things your survivors can use life insurance for (as long as you get before you become uninsurable).
pay off debt
pay for non-retirement expenses such as education, career, and training expenses
survivor's retirement income
estate or legacy goals.
Here is a hypothetical example. (This is NOT advice here but just some numbers for you to understand a "build your own coverage" approach to life insurance). So let's add some numbers up. | $350,000 to pay off mortgage and the car and the credit cards | $150,000 for non-retirement | $ 500,000 for retirement | We will stop there and I will cover estate and legacy strategies in Q4 2014..
So $1,000,000 term policy for couples that are young (permanent insurance for older folks who have discretionary funds to prepay future premiums) and have had not time to accumulates assets but just debt. That number could go down if Social Security is factored in, if the survivor has wage income, and the home sale is used to add to savings and a rental living arrangement is considered. The bottom line is that YOU can decide what you want to insure for by just doing a little math and some planning. As your debt drops and your survivor period (in years) reduces, you can consider reducing your life coverage and start to shift premium dollars from protecting your income to long term care coverage (protecting your assets). More on long tern care strategies later next quarter.
Look for new content in Q4 2014 to include: