Tuesday, April 16, 2013

My Assessment on Financial Risk Management

Risk…It’s certainly a combustible topic and one I would love to explore today.  What got me in a tussle about this topic was a recent publication I read in a magazine geared towards professional investment advisors. And what did I learn after an entire issue dedicated to risk? That most financial advisors use $100 words to tackle this $2 challenge, and charge accordingly. 

While I’m not one to make light of risk, the attitudes toward it in the investment world are straight out frustrating: yes I agree that risk runs on opposite spectrums: do no investing and keep your money under a mattress or a simple savings account and that risk will cause you to lose purchasing power due to inflation over long time periods.  And when it comes to investing, well, a lot of financial snobs will tell you that intricate risk strategies are the way to go when investing.

Allow me to assert that spreading your investments across equities, bonds, futures, commodities, real estate, R.E.I.Ts., ETFs, single stocks, fund of funds and securities lending, all in the name of risk management is just plain stupid.

Never let a slick guy in a suit make decisions or develop strategies for you. More often than not, all these “risk management” strategies do is take away the risk of the advisor missing out on their commission.
So let’s explore what risk is before I share how I manage it in my portfolio.  At its core, risk is about losing money, whether due to inflation, taxes or an investment loss, in the financial realm risk is about the fear of losing money on your investment.  Whether the single stock drops, real estate crashes, we hit a recession, or that 92 day Gold Future just doesn't go your way.  We all have a fear of losing what we put into our investments.

No one has a crystal ball and can dictate what the overall market is going to do in the short term.  To me the best we can do to minimize risk is to take the best, well-informed, well-educated and well calculated risk. Looking historically at measures like the DOW and the S&P, we can see consistent trends that in 5, 10 and 15 year periods of time that equities have consistently risen.  In a broader context equities have grown, in long term time horizons, bigger, faster and stronger than bonds.

I’m not going to jump in and out trying to time the market. I don’t know what it’ll do day to day, month to month, or year to year.   But history shows that in long time horizons, equities win out over any kind of investment for growth.

So before I bought my first investment, I put my emergency fund in place. I set aside 6 months’ worth of living expenses, to keep from having to sell my investment for at least that same period of time (6 months). I’m investing for the long haul and planning to ride the 5, 10 and 15 year tidal waves by buying and holding.

When I did look at investments I acknowledged my limitations. I can’t pick or find the next Google, Apple or Disney - neither can nerds who live and breathe the market, neither can a dart board, and neither can you. So to maximize growth and capture equities without single stocks, I use mutual funds.  Mutual funds are baskets of stocks and depending on the size of the funds can hold essentially hundreds or even thousands of stocks.  I only buy proven winners that have been around for at least 10 years and have at least 12% average annualized returns since inception.  I buy 4 types of mutual funds: Growth, Aggressive Growth, Growth & Income and International.  This way my investments capture thousands of companies across dozens of sectors across the entire world.

I don’t invest with intent to make 5-7% on my money, I aim for 12% average annualized returns every time. Gold would drag my number down. Bonds would drag my number down, oil and pork bellies would drag my number down. Betting Microsoft will rise in stock price by 6% over the next 60 days will drag my number down. And lending my securities to the open market to try and short the price, you guessed it, will drag my numbers down.

But what about ’08?  My investments fell just like yours. But I didn’t lose a single penny. I held everything I bought up to that point and continued to regularly invest in my little army of mutual funds through the dip and through the current mountain peak today. And this strategy has thus far earned me 16% of my investments.

No tricks, no gimmicks and no magic carpet, just simple and straight forward thinking. Owning “sets” of different asset classes is not diversification. It’s stupid, keeps your hard earned money from building at a higher rate and puts a little extra coin in everyone’s pocket but yours.

I’ll end this tirade by picking on bonds. More often than not, bonds are considered safe investments. For generations now advisors have told us that as we approach retirement to shift a heavier allocation towards this “safe investment.”  But these goobers never tell us, that while we make 6% on that bond over decades, we’re missing out on an extra 6% of compounding growth during that time. And especially now, as retirees hold bonds in higher weight, when interest rates rise and bond prices fall, it’s going to be a blood bath out there for the “safe investment.”  The only safe investment is the well-calculated and thought through risk.

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