Dear Clients and Friends:
Several years ago a couple met with us for the first time. She felt they would benefit by working with a financial advisor, but he wanted us to understand that he would not accept any risk. I asked: “How did you get here?” He answered: “We drove, of course.” I said: “I thought you said you would not accept any risk.” He hesitated and then understood that there was great risk in driving an automobile on public highways. He had accepted – and then managed – that risk. The same principal applies to all of life’s risks.
However, in this letter, we will focus only on financial risks and ways to manage them. Here is a brief explanation of some of the more important risks.
1. Goal Risk is simple – it is the risk that despite your best intentions, you end up not being able to meet your goals and expectations. In our opinion, this is the greatest financial risk.
Part of Goal Risk is not being clear about what your goals really are. Sometimes people focus so much on the details of financial matters that they lose track of how money can affect family relationships. Excessive worrying about or focusing on money can have negative physical, emotional and even financial consequences.
2. Uncertainty Risk is seldom factored into long-term financial and investment plans. It is the risk that, no matter how detailed your projections might be for future earnings, inflation, taxes, etc., it is inescapable that “things change.” For many people the plans they developed over the years work out wonderfully. For others, health or job disruptions, investment decisions or family needs have resulted in outcomes not originally projected. Sometimes these outcomes have been very positive, sometimes not. The point is that life is not a straight line, and that built into every life and financial plan should be the recognition that uncertainty may deliver unexpected results.
3. Principal Risk is the risk that the investment you made will become worthless or close to it. Two recent examples would be people who bought Enron stock, and people who purchased homes they could not afford before the real estate crash in 2008. However, many people avoid the stock market in the belief that it could go to zero. For this to happen all the major companies of the world have to go bankrupt. If that occurred there would be no banks from which to withdraw money, no grocery stores to sell food, no oil companies to sell gasoline, etc. The point is that as long as your stock market holdings are diversified, the likelihood of having your stocks go to zero is minimal, and if it does occur, then life would be so drastically different that we would all be back in a barter society.
4. Interest-rate Risk is the term which describes how changes in interest rates affect world economies and global stock and bond markets. Generally there is a direct connection between interest rates and bond values. When interest rates rise, bond values usually drop, and vice versa. (How much they rise and fall depends upon the kind of bond – and there are many different kinds of bonds!) However, while rising interest rates can affect stock market values, rates are only one of the many factors which influence stock market fluctuation.
5. Geo-Political Risk describes how war, revolution, terrorism, scandal and other phenomena around the world can have an impact on our investment strategies. Often the markets react the opposite of what might be expected. Experts predicted stock market declines the days before the US was poised to invade Iraq in both 1990 and 2003. Instead the markets rose dramatically.
6. Political Risk has two parts. The first part is that elected officials will enact laws and policies which will be harmful to one’s investment strategy. The second and bigger risk is that investors will change their well thought-out investment strategies because they become convinced that the “other” party will enact laws and policies which will be harmful to the economy and/or the financial markets.
7. Headline Risk is the tendency of rational, intelligent people to, unknowingly, absorb the daily barrage of bad news and become so disturbed that they make decisions driven by emotion and not logic. As a result they can end up jeopardizing their long-term goals and objectives.
8. Purchasing Power/Inflation Risk is the slow erosion of your ability to maintain your lifestyle because “a dollar doesn’t buy what it used to.” Avoiding fluctuating assets may allow you the peace of mind of knowing that your account balance cannot go down. We describe it as the “safest way to lose money,” because a 3% increase in the cost of living represents a real loss of $3 per year on a $100 initial balance.
9. Decision-Making Risk is a result of all the successes and failures of our earlier financial decisions, and of the philosophies and behaviors of those whose examples molded our views of the world. My own grandfather, for example, who raised a family during the 1930’s Depression, would never own a home because he could never accumulate the cash needed to buy a home outright, and he would not permit himself to owe money to a bank.
10. Fluctuation Risk occurs when an investment does not have a fixed resale price. Examples would be your home, a business, and (of course) publicly traded securities such as stocks or bonds.
Notice how the volatility of the financial markets is the financial risk that gets the most media attention. However, we believe in most cases, for most people, Fluctuation Risk is the least important risk you face when building plans designed to help you achieve your financial goals.
11. Longevity Risk is the risk that you will run out of money before you die. We should always keep in mind that our ultimate goal is to have financial stability for our entire lives. All other risks should be managed accordingly.
We are well-advised to avoid worrying about things over which we have no control. We should focus on what we can control. This includes how we react when things go right or when things go wrong, how we maintain our health, and how we manage our relationships with family and friends. Finally, we should remember that money is only a tool, a tool whose greatest use is to help us live the lives we wish for ourselves and our loved ones.
Please contact us if you would like to discuss how we can help you manage the many kinds of financial risk.
Thank you again for the opportunity to work with you.