Archives for risk management category
5
Dec
Posted in Mixed Bag Monday, risk management by Roger, the Amateur Financier |
If you are a long time reader, you’re probably well aware that I tend to be a somewhat negative guy. There’s not particular reason that I can point to for why this is; it’s just the way I have always been, ever since I was quite young. I’ve just always seen the glass as half empty (and even that was usually being optimistic).
As a result, it probably hasn’t surprised anyone that I’ve written more than a little bit about emergency funds and other means of keeping your head above water when trouble strikes. There’s plenty of financial instruments available to help you minimize your risks, and there’s seldom a good reason not to take advantage of them. So, here is a short guide to some of possibilities that are out there:
Q: What sort of insurance should I have?
A: This tends to be a tough question, if only because there are so many types of insurance out there, as well as different situations for everyone. At minimum, you should have: health insurance (frequently provided via your job, here in the US), disability insurance (necessary as long as you work for your money), homeowner’s/renter’s insurance (to cover your lodging), and automobile insurance (if you have a car). Other types of insurance are less of a cut and dry matter; your need for life insurance, in particular, depends on who depends on your income. Speaking of life insurance…
Q: Should I go for permanent life insurance?
A: Short answer: probably not, as term life insurance is less expensive and simpler. Longer answer: permanent (or cash value) life insurance do have some advantages, building up a (sometimes substantial) cash value from which you can borrow later in life. If you have a lot of trouble saving and investing unless you are forced to do so, they might be worth considering. Make sure you do plenty of research and get unbiased (that is, not trying to sell you an insurance policy) help before you opt for a permanent life insurance plan, if you end up choosing one.
Q: How much of an emergency fund should I have?
A: You will get more different numbers for this than almost any other (non-investment) personal finance question. These numbers, generally cited in months of expenses, range from as little as one month to twenty-four months. It’s hard to narrow it down to one answer that serves everyone; your best bet is to find an amount that works for you. My advice: three months as a good minimum (particularly if you have dependents) and one year is a pretty solid maximum (after that, you can start to blend your emergency fund into the safer portions of your investments).
Q: Where should I keep my emergency fund?
A: With an emergency fund, the key is safety above else, with ease of accessibility coming a close second. You don’t want to lose your money the moment you need it, or be unable to get to it when the need arises (or have to pay stiff penalties for the privilege). You’ll want to stick with a bank account for the first few months’ worth of savings, only considering higher earning alternatives (CDs, money market funds, possibly even bond funds) when you build your savings even higher. You also want to keep some cash on hand, just in case.
Q: How much money should keep as cash on hand?
A: Generally, you want to keep a sizable portion of money, probably a few hundred dollars as a bare minimum, in a safe place at your home (not on your person, as there is the possibility of it being lost or stolen); there are too many examples of natural disasters or other emergency situations where it becomes impossible to use cards or get money from a bank. How much beyond that will depend on how likely you consider such a situation, as well as how many options you have for other sources of help in such emergencies.
Alright, that’s enough of the doom and gloom, even for me. Hopefully, you will not need to use insurance or your emergency fund any time in the near future (or ever), but if such a situation arises, at least you’ll be prepared. And really, sometimes that all you can ask for.
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6
Jul
Posted in asset allocation, risk management by Roger, the Amateur Financier |
One of the very first things that just about any person, magazine, book or blog about money and investing will tell you to do when you are getting started in the investing game is to determine your risk tolerance. It’s one of the most common pieces of advice you will encounter while you read up on investing, along with diversifying your investments and dollar cost averaging (that is, making regular investments of the same amount, regardless of what the market is doing).
But, just what is this whole risk tolerance thing? Why does it get such prominent mention in so many sources of financial advice? How can you determine your own risk tolerance? More to the point, what should you do about once you know your level of risk tolerance? In this article, I hope to shed some light on how you can answer all these questions.
Risk Tolerance 101
So, what is risk tolerance? The general concept, as so clearly illuminated by Investopedia, is that it’s the degree of tolerance an investor has for suffering losses in their portfolio. With any investment, there’s some degree of risk; risk that the investment could decline in value, risk that dividends could be decreased (or cut entirely), risk that the company or organization backing the investment might go bankrupt and the investment will become worthless. It’s impossible to find a completely risk-free investment; even Treasuries, often considered the low-risk standard by which risk levels are judged, have some risk. (Particularly if the US government doesn’t get this whole debt ceiling increase mess taken care of before the end of the month…)
Before I get anyone too upset talking about the deficit, here's a puppy.
Your risk tolerance, then, is basically a measure of how much threat of loss (risk) you can handle (tolerate) in your portfolio. If your portfolio could drop by 50% tomorrow without adversely affecting you (at least, immediately), you have a very high risk tolerance; on the other hand, if a more modest 10% decline has the potential to seriously derail your plans, you have a low risk tolerance. This risk tolerance will change as you go through life, particularly as you get close to retiring; when you are thirty years away from retirement or so, you can tolerate the possibility of a decline in your investments much better than when you are three years away.
What Determines Your Risk Tolerance?
There are quite a few factors that determine how much risk you are able to tolerate in your investments. Here are three of the most important to help give you an idea of what you should consider:
1. Length of Time Until Retirement (Or Your Other Financial Goals): Probably the biggest determinant of your risk tolerance is how much time you have available to meet your desired goal. As mentioned above, you’ll have a much greater risk tolerance with three decades until it comes time to start drawing down your investments, rather than three years. While retirement is obviously the biggest goal most of us will save for, there are other goals where investing might be helpful (building up money for a home, providing money for a child’s college education, etc.), and so it’s possible you might have different risk tolerances for different goals.
2. How Much of an Increase You Need to See In Your Money: Depending on your particular goal and the amount of time you have to reach that goal, you might need to take on a higher level of risk (or you may be able to decrease your level of risk). If you are able to save only a fraction of the amount of money you will need in retirement, for example, you’ll need to use investments that have higher growth potentials than if you were able to save all the money you need (and thus, only had to worry about preserving your wealth). If you need, say, 8% average annual growth to meet your retirement goals, you’d have to invest in something like stocks, which offers the potential for high growth coupled with the possibility of substantial losses.
3. Your Emotional Ability to Handle a Financial Loss (or the Potential for a Financial Loss): No discussion of risk tolerance would be complete without mentioning your personal tolerance. If you are likely to pull all of your money out of the stock market at the first sign of a dip, and get back in until the market has already shoot back up, you have a low risk tolerance. (That said, when investing, you should try to take your emotions out of the picture as much as possible; if you get too emotionally involved, you’ll end up making unwise monetary decisions and hurt yourself in the end. Try to disengage your emotions as much as possible while investing.)
How Do I Find My Risk Tolerance, and What Do I Do With That Information?
Ah, the $64,000 question. There are risk tolerance questionnaires offered by most investment and money management firms which can help you to get an idea of how much risk you can tolerate. If you answer them honestly, and really try to picture yourself going through the scenarios they present, you can get a decent idea of how much risk you can tolerate.
That said, while questionnaires can be useful, they aren’t perfect; it’s easy enough to say that you’ll ‘weather the storm’ when something goes wrong or ‘double down’ on investments that have a single bad year, but when it happens in real life, it’s a much different situation. A better view of your REAL risk tolerance could be gathered by looking at what you did during the last downturn; if you pulled all your money out of stocks, you probably have a very low (emotional) risk tolerance, while those who started putting as much extra into their investments as they could afford have a high risk tolerance.
What do you do with this information? Well, first you can tweak your investments to more accurately reflect your risk tolerance. If you have a low risk tolerance, consider increasing the amount you allocate to safer investments like bonds and cash equivalents. Don’t change so much that you put your goals at risk, but if shifting 5-10% of your portfolio makes it easier for you to sleep at night, it’s probably worth a slightly smaller investment return. Similarly, if you have a high risk tolerance, consider bumping up your stock allocation; you should be able to handle the higher potential losses, and the increase could speed up when you reach your investment goal.
That said, though, don’t let your personality get in the way of your financial goals. Tweaking your asset allocation is one thing; completely changing it, by going all bonds twenty years before you retire or all stocks one year before you retire, is another. If you let your personality dictate your investments more than your current financial needs, you could end up hurting your financial plans as a result. After a small adjustment, if that, you should leave most of your portfolio alone, although you can consider…
Setting aside a small portion of your portfolio to meet your emotional needs. If you simply can’t help the urge to fiddle with your investments, use five or ten (definitely no more than twenty, and even that’s a bit much) percent of your portfolio and invest it however you wish (in a separate account, of course). If you have a high risk tolerance, you could invest it in speculative stocks or other types of speculation, with the knowledge in the back of your head that even a huge loss won’t mean that you’re stuck working until you’re ninety-five. If you have a low risk tolerance, you can invest it in rock solid blue-chip stocks or bonds, and use it to remind yourself that even if the market is delivering a beating to your main retirement portfolio, you still have a nice reserve. (And that, when the market picks up and your main portfolio recovers, you aren’t going to be left behind.) Make sure that your main portfolio is invested in a way that meets your financial needs in the appropriate amount of time, and use the side portfolio as a supplement to express your emotional investment needs. Adding a little distance between your emotions and your portfolio can be a great help in keeping them from overwhelming you and causing you to make bad decisions.
How much risk can you tolerate? How do you keep your risk tolerance from causing you to make poor investment decisions? How much should your risk tolerance affect your investment style?
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24
Jan
Posted in automobile, risk management by Roger, the Amateur Financier |
It seems like only two weeks ago, I was driving to see my fiancée and had trouble with my car leading me to take it in for repairs after a harrowing drive. Actually, it was two weeks ago, almost to the day. Luckily, I made it to my destination alright, and got the problem (a power converter in my dash board) fixed without spending too much time and money doing so. That should get me a few months without car trouble, right?
Alas, that’s not the case; less than two weeks later, I found myself having further problems, this time not with my lights, but with my brakes. That might not have been such a problem, were it not for (a) the snow, ice, and slush on the roads of Ohio in the winter, (b) the steep hill that I need to drive down as part of my commute from school to my apartment, and (c) other cars that have the audacity to be on the road at the same time as me. I think most of you are probably already forming an idea of what my trip home was like, but just in case you were still curious…
My Harrowing Homeward Journey
Getting to school on Thursday wasn’t too bad. I had noticed for the past few weeks that my anti-lock brakes were engaging more often, and I was having a little trouble coming to a sudden stop. But I wrote that off as what happens when you are driving in January in Pennsylvania and Ohio; there is no lack of ice on the roads, and when driving a beast of a car that’s over a decade old, a little bit of skidding was par for the course. Drive a bit slower, brake a bit sooner, and don’t be aggressive, and you’ll be fine (good winter driving advice in general, while we’re on the subject).
Grow up in Pennsylvania, and you get used to driving on roads like this.
Trying to get home from school was a whole different matter, however. Exiting the parking garage wasn’t that hard, although as I was driving down one of the parking lanes toward the exit, I was unable to stop in time to avoid cutting off another car. The driver seemed to take it pretty well, and waved me forward, although she may simply have been unable to get past me.
On the open road, though, I soon had some serious problems. I was in the middle lane on a downward sloping hill with cars stopped for the light at the bottom of the hill. I tried to stop my car, pressing the pedal, trying to pump it, slamming it to the floor; no use, I wasn’t stopping. Without doing something drastic, I was certain to hit one (or more) of the cars at the bottom of the hill; even at my 20 mph (32 kilometer per hour, if my conversions are correct) speed, I could still do quite a bit of damage to their car and mine, to say nothing of the insurance complications, higher premiums and other such headaches.
Needless to say, I wanted to avoid this sort of situation, and so attempted a rather…questionable maneuver. I cut across the right lane of traffic (nobody was coming, luckily for me), hit the curb, went OVER the curb (I was kind of hoping it was stop me, but again, my car is a bit on the large side, and objects in motion, stay in motion-Thanks, physics!), and ended up making an unplanned right turn when I came back down. It was rough, to say the least, but after hopping the curb, my car was going slow enough for my dying brakes to stop me.
I drove my car to the nearest place I knew could fix my brakes, slowly and cautiously, with my hazard lights flashing most of the time (I’m sure the people following me must have loved that). There, I found out that my brake line was broken, and my car had lost most of the brake fluid. After thanking my lucky stars, I agreed to pay the over $600 bill, and settled in to wait for the repairs to be done. When they were finished (taking longer than they expected, and going past their closing time), they returned my car, billed my credit card (much less than the quoted price, which I figure was due to that extra-long wait), and let me get on my way with my now functional car.
The Lessons Learned
I suppose I should try to pull some helpful lessons out of this situation; lemonade from lemons, and all that jazz. When I last took my car for repairs (that above linked post), I came with a few lessons about keeping up on my car’s maintenance and trying to help out other people. Since all the same lessons apply here, I won’t rehash them. (Other than to note that helping out others (either clients of your business or complete strangers) can pay nice dividends, both in increased business and better karma and that catching any under performance by your vehicle can help you get ahead of the curve and possibly even save your life.)
Instead, I’ll point out a different lesson that two car emergencies occurring within the same month has taught me: keep a substantial emergency fund. Actually, as I’ve discussed before, you should ideally have a spectrum of emergency funds, providing you with additional sources of money to fall back on if you need them. Particularly if you are trying to get out of debt (or avoid falling back into debt), having enough money available to weather not only AN emergency but MULTIPLE emergencies will be essential.
And how much money is that, you ask? Most financial advisers will cite a number of months of income, which is a pretty good metric for an unemployment fund; that is, the part of your emergency fund you set aside in case you lose your job. (Which, I will tell you from experience, is a pretty big emergency.)
But what about the sudden, unexpected expenses that we more typically think of as ‘emergencies’? Things like your water main bursting, your refrigerator dying, or yes, your car needing major repairs? Having six months of your normal expenses saved should be enough to cover those incidents, but depending on your normal spending and the cost of these emergencies, it might not be. If you are a low earner who suddenly needs major car work (or to buy a whole new vehicle), three to six months of income might not cover it. If you are trying to be debt free, you should make an effort to build an emergency (buffer) fund that will cover the largest foreseeable emergency you might face. (If you, like me, do go further into debt to cover your emergency, one of your top priorities should be to increase your debt repayment schedule to compensate.) In my case, that would be replacing my car; while hopefully not something I will have to face soon, building a fund to cover the purchase of a gently used car when my current one finally quits on me is a goal I’m adding to my list.
Once again, my car has given me trouble, and once again, I’ve managed to get a pretty sizable post out of the ordeal. Not that I’m hoping for more automotive troubles, but if things keep up this way, my car might end up becoming the biggest source of inspiration that I have.
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13
Sep
Posted in risk management by Roger, the Amateur Financier |
It’s Monday the Thirteenth! Bad luck is everywhere! Everybody panic! Alright, Monday the Thirteenth doesn’t strike quite as much terror into the average person as, say, Friday the Thirteenth (maybe a film series featuring a supernatural killer and numerous scantily-clad coeds being slaughtered would change that), but while we’re on the subject of bad luck…
The simple fact is that bad things happen to us; as they say, ‘Into every life some rain must fall’, or any number of other cliches. There’s no way to avoid it, so instead we have to look at how we can make it easier to get back on our feet when bad times strike. In honor of the Thirteenth, here’s thirteen things you need to make sure that you’re ready when bad luck hits:
1) An Emergency Fund: A prerequisite for any emergency preparation, having money set aside specifically for the bad times that occasionally befall us all is vital. I would go a step further, recommending that you create a step-like system of multiple emergency funds, to ensure that you can make it through any length emergency. But even a simple savings account with some money to provide for an unexpected expense is a good start.
2) Cash On Hand: I mention this in the emergency fund topic I linked to above, but it bears repeating: occasionally, you will need access to actual, physical cash, usually because that’s the only payment medium being accepted. (Think about the aftermath of most major disasters, from earthquakes to hurricanes.) While you don’t need to carry a month’s salary on you at all times, a few hundred dollar bills (or the equivalent in your own local currency) in a secure but accessible location could make the difference if you happen to find yourself getting the short end of nature’s stick.
Ah, cash; always good to have a nice supply of you on hand.
3) A Road Repair Kit: If you have your own car, you probably already keep one of these in the back seat or trunk. While you shouldn’t expect to bring your car back from a major crash (or even anything more severe than a flat tire), the ability to make minor repairs can, over the course of a lifetime spent driving, save you significant amounts of money (to say nothing of hours spent waiting for repair people to arrive).
4) Home Repair Supplies: On the same token, having the supplies (and the skills) to make minor repairs on your home can be a major time and money saver. Don’t try to do more than your skills allow (particularly when it comes to potentially dangerous tasks, like electrical wiring), but things like patching a hole in the wall or fixing a minor leak shouldn’t strain your abilities too much.
5) Health Insurance: Ah, yes, there’s really no way you can talk about protecting yourself from bad luck without mentioning insurance. If you live in the US, you probably get your health insurance through your employer; if not, you’ll need to seek out your own health insurance (typically at much higher prices). It’s still better to have insurance than not, though, so shopping around for the best combination of price and service is usually your best option.
6) Life Insurance: Life insurance is less of an absolute; while it’s definite that you will die at some point (sorry to be a bummer), you only really need life insurance if you (a) have one or more people who depend on you for financial support and (b) don’t have adequate savings to provide for them when you’re gone. If you’re young, unmarried, and have no kids, or if you’re already retired and have a sizable amount of money put aside for your family, you can do without life insurance, while the middle-aged guy with a wife and young kids definitely should get life insurance. There are several types, but for most people the best option is a term life policy to cover your prime money earning (and family supporting) years.
7) Homeowner’s/Rental Insurance: You need a place to live, and while you’re living there, you’ll also need to insure your property. Not only to help you regain all your stuff in case of a fire or other emergency (although, that is a plus), but also to protect you monetarily if there is an accident in your residence. Which type you’ll need depends on whether you rent (rental insurance) or own your property (homeowner’s insurance), although in both cases, you should look for replacement cost policies (which will provide you with enough money to repurchase all your possessions) rather than an actual cash value policy (which will pay the (depreciated) cash value of your possessions).
8 ) Other Forms of Insurance (As Needed): I could probably have filled this entire list with different types of insurance, but let’s try to wrap things up. You should also consider disability insurance (in case you are injured and unable to work), long-term care insurance (to provide for you in your old age), and if you have a car or other vehicle, automotive or other appropriate vehicular insurance (not only to protect your savings in the case of an accident, but also because it’s the law in many states). Your exact insurance needs will vary according to your current financial situation, so do some research and plan accordingly.
9) First Aid Kit: Insurance is good and all, but sometimes you need a more immediate, non-financial fix. Keeping a first aid kit or two (as well as the skills to use it properly) in your home, car, and possibly even your place of work will help when you or one of your companions inevitably gets injured. Of course, you also need to know how to use your first aid kit, which brings us to…
10) CPR Training: Chances are that you have more than a few opportunities to learn CPR and other first aid techniques; from local community college offerings to training seminars provided by your business, you should be able to find somewhere to learn without a problem. The trick is finding the time to attend; hopefully, the idea of being able to save your family members (and possibly revive some of those old Boy/Girl Scout memories) can help to inspire you.
11) A Will: Annnddd we’re back to the fact that you are mortal, and will die at one point. (Unless you happen to be a Highlander, in which case I suggest you spend all your free time working on your sword skills.) A will can help, by ensuring that your possessions and money will be distributed to your family and anyone else you want to inherit from you. Unfortunately, if you only have a will (which is still more than many people have to stipulate their wishes) your heirs are likely to end up in probate court, while a judge decides what happens to your earthly possessions. You can avoid this situation by having…
12) A Living Revocable Trust: The nutshell version of a living revocable trust is that it serves as a way of passing on financial or other assets to your heirs without having to visit probate court along the way. You create a legal structure (a ‘trust’) that holds your assets, and transfer control of that trust to your chosen heirs. You’ll bypass the probate system entirely, and make sure that there aren’t any problems when they inherit your property. (While we’re on the subject of your last days on Earth, you might also consider setting up a durable power of attorney, to specify what health measures you want taken to preserve your life and whom you want making decisions about your health if you are unable to do so. As with all of the suggestions on this list, it might seem a bit morbid, but better safe than sorry when the time comes…)
13) A Life Free From Regrets: Last, but far from least, you should do everything in your power to make sure that when you pass on, you don’t leave life with regrets. From the things we wish we could have done to the unresolved fights with family and friends, there’s lots of reasons we might leave unfinished business here in the mortal coil. It won’t protect you from bad luck, and doing your best to resolve these issues and regrets before you die will not make dying any easier, but having no regrets will hopefully give you a better sense of closure while you die.
There you have it, a lucky thirteen ways to protect yourself from bad luck. Hopefully you won’t need to use the protections suggested here for a very, very long time, but as I’ve been stressing throughout this article, it’s better to be safe than sorry. Good luck, everyone!
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