While most people focus on volatility, there are other more subtle and arguably more important risks.
There are several risks that are a part of investing and everyday life. While most people focus on volatility, there are other more subtle and arguably more important risks.
1. The risk of inflation
The purpose of investing is to ultimately either spend or give your money away at some future date. Therefore, what your money can buy you at that later date is critical to understand. Inflation is like salt on a car -- it gradually erodes your spending power year in, year out. The effects are hardly felt immediately, but over time the impact is significant.
Don't be fooled by the consumer price index. You have your own personal inflation rate.
Certain costs will increase faster than others. For example, since the deregulation of the airline industry, travel costs have fallen compared to what they were decades ago. However, the likelihood of that continuing into the future is slim. If you travel a bit, your personal inflation rate will be much higher than a homebody.
2. The risk of outliving your assets
Some clients say that they want a portfolio that will be a last-breath, last-rupee portfolio. But that is not realistic. It is virtually impossible to know how long that you will live, so you need to develop assets in a number of areas that can keep on going as long as you can.
Pensions are an example of this. A well-reasoned spending policy for your investment portfolio that provides appropriate safeguards in various market environments also will provide you with protection from too little money too late in life.
3. The risk of not enjoying your assets
Just like having too little money late in life can be an issue, so can having too much money. Many of our clients who have been so responsible in building their portfolios throughout their working days have a terrible time spending that money when they retire. How sad.
Clinging tightly to your money and letting it slip mindlessly through your hands are actually two sides of the same coin. Finding the golden mean is the key to successful financial planning.
4. The risk of big-cost items
Insurance should only be for the things that you don't feel that you can pay for on your own. You could consider insuring your home -- after all you may not be able to afford a replacement to your house if it burns down.
The same thinking should be for things like long-term care insurance, disability insurance, and life insurance. Don't skimp on them nor use these products as investments; use them as a way to protect against the things that you can't cover on your own.
5. The risk of not living the life you wanted
Too many people focus on the little stuff and forget the big things. They may be obsessed with fees that they are paying and ignore whether they could spend their money on improving their lives in some way. I use my childhood as an example. My mother would trudge into our dark, damp basement to do laundry for the 20-some years my parents owned their house. When they were getting to sell it, they completely redid the laundry area. Why spend that money for someone who doesn't even matter to you?
6. The risk of tying money up
Too many people are enamoured with things that they can't get their money out of when they want to; hedge funds come to mind. While these may be appropriate, the key piece is that if someone is going to take your money for a long period of time because of lock-ups or simply the type of investment, you better be compensated for it. Generally speaking, you aren't.
You can create your own portfolio using exchange-traded funds and open-ended mutual funds that can do many of the things that hedge funds do, without the high fees or lack of liquidity.
The calculus for most clients really comes down to this: How much risk do they need for the amount of money needed to live the life that they want to live?
We have clients with a lot of money who do not feel that they want to leave much to their heirs. Once we solve for their charitable intentions, they simply don't need to take on as much risk as someone with a similar amount of money but different objectives. This is not the situation for most investors.
We do a lot of modelling for our clients using a wide range of assumptions. We spend a lot of time coaching and talking to our clients about what is realistic for them. It really comes down to eating well versus sleeping well. Remember, any act of saving is an act of deprivation -- you are denying yourself something certain today to help you have something in an uncertain future.
This also makes saving an act of faith. Most people tend to not want to be all-in or all-out, so we can modify things that leave them emotionally comfortable and financially secure. But there are some people who don't want to accept any risk of volatility. They need to save plenty of money because they should only be invested in government-backed instruments which are not going to pay very much.
This article was initially written by Ross Levin for Morningstar's UK website. Levin is the founding principal and president of Accredited Investors, a US-based, fee-only financial-planning company.
Photograph: Artis Pupins/Creative Commons