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Risk PDF Print E-mail
Written by John D. Buerger, CFP®   
Wednesday, 14 April 2010 15:01
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John Buerger

Risk is a challenging thing.

It is challenging when you're on the wrong side of it.  It is challenging to adequately define.  And it is especially challenging for most people to identify.

Human beings are hard-wired with a number of circuits in our brains that allow us to cope with the complexities of human existence.  Many of these circuits create short-cuts so we don't have to waste limited energy processing data that is nothing more than noise.

Normally, these short cuts are a good thing.  Resources and energy are limited, after all.  But they do create biases in our perception of what is going on around us.  A common bias that can often result in poor financial decisions is something we call "Recency Bias" - taking recent experiences and trends and projecting those trends into the future.

Sometimes this is referred to as "Linear Thinking."

The stock market has been going up the past twelve months.  There is a comfort to that trend and bias to believe that the odds are really good that it will continue to go up.  After all, "the trend is your friend."

It is ... until it isn't.

THINGS CHANGE - S&*! HAPPENS

No trend lasts forever.  Bull markets end.  Interest rates change.  Unemployment goes up.  People lose jobs after they've had them for years or decades.  Then after months of unemployment - right at the point where some might become frustrated and give up looking - they get a new job.

When a sports team is winning a lot of games, they play better ... so they win more games.  The players feed on this momentum.  But eventually it ends.  It always ends.  Once the losing begins, it is just as difficult to get back to winning.  Recency Bias (or Linear Thinking) is the main culprit behind winning and losing streaks.  It is also a major driver in investment market psychology.

The most dangerous aspect of linear thinking is that it gravely clouds your ability to identify and protect yourself from risk - those potentially dangerous moments when the results are substantially different from your expectations.

When things are good, it is easy to get lulled to sleep, thinking that all will remain well and good.  It is precisely at the time when vigilance is at it's lowest that something comes along and changes everything.

YOUR RISK

Your life is filled with risks.  You could be affected by any one of thousands of diseases.  You could be in an auto accident with no warning.  These risks could greatly affect your health.  Risk is everywhere.  It is just like that "noise" that your brain circuits are so good at ignoring.

Rather than ignore risks, it is better to understand what they are and where they exist.  After that, you should know what it will cost to protect yourself and minimize each risk.  From there you are then ready to make the best decision regarding whether or not you want to pay for the protection.

You may choose to "let it ride."  But at least you won't be surprised when you lose everything right at the point when you thought everything was going great.

MONEY RISK

But what about your wealth - your life savings?  Your income?  Your future?  How safe are they?

The answer is, "Not safe at all!"  While there are many people who understand this and you may be nodding your head in agreement, I really feel that most people underestimate the degree of risk to which their wealth is exposed or they don't understand the tools they can use to protect themselves from that risk.  They aren't getting straight advice from the media or their advisor (if they have one).  I see it every day when I meet with new clients.

If you really understood the risks to which your money is exposed you would:

  • Save a minimum of 15% of every dollar that you make.
  • Have cash reserves of at least six months of expenses (or more).
  • Have an estate plan including a living trust, powers of attorney, health care directives and guardians (both short and long term) named for your children.
  • Have hedges in place on ALL of your investments.

You would do all these things (and many more) because you would see that not doing these things exposes your family to tremendous amounts of needless risk.  But very few people do even one or two of the bullets on this list, much less all four.

For today, I only want to quickly address that last one:

HEDGING YOUR INVESTMENTS

There are a number of ways you can hedge your investments.  You can put all the money into CD's and FDIC insured bank accounts.  That get's rid of the risk of loss.  It does nothing to protect you from inflation risk and is a grossly inefficient way to put your money to work.

You can put the money into an insurance contract like an annuity.  That could eliminate the chance of a loss.  You will lose liquidity in the process (thanks to surrender charges) and there is the possibility, albeit a remote one, that the insurance company might be unable to honor the contract (even though they are required by law to carry substantial reserves).  Still this is a decent option for some people.

You can diversify your portfolio.  Proponents of Efficient Market Hypothesis do have math models that show you can diversify away a lot of risk, but even a well diversified portfolio will take a massive hit in a market meltdown.  We proved that in spades in 2008.

You can just buy bonds and stay away from equities.  That's what a lot of people have done the past year and they have a great track record now to show for it.  Bonds have been in a bull market since the early 90's as interest rates have come down.  But there is a huge risk that those seemingly safe bonds (remember the trend and linear thinking) are sensitive to interest rates which have no place to go from here but back up, reversing the trend and creating losses in what people perceive to be a "safe" investment.

There are other, more sophisticated strategies you can follow including option straddles, private placements, real estate and placing stop loss orders.

LOTS OF OPTIONS

There are no SAFE ways to protect 100% your money.  Risk is everywhere and no one solution is the best solution for everybody.  Protecting your money comes with a cost - which is a drag on growth - but most people would prefer a small drag on growth to losing 20, 30 or 50% of what they have worked so hard to save over their many years of life.

Then again, many people don't realize they ARE at risk to lose 20, 30 or 50% of what they have.  That's the first step - to understand the risk.  Then you can talk about protecting yourself from it.

My suggestion is to start by asking yourself this question: "What ARE the real risks to which my wealth is exposed?"  Once you honestly understand those risks you can look at the various solutions that are available and what they cost.  From there you can make the best decision as to how much protection you are willing to pay for.

I also would suggest that if you have an investment advisor and that person has not discussed one of these hedging strategies with you (option straddle, stop loss, alternative investments or move to an insurance product) that you find a new advisor who can be straight with you about the risks to which they are exposing your hard earned wealth.

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Last Updated on Thursday, 15 April 2010 00:07