A Discourse on RISK

Written By — David Shafer

Financial risk is a very misunderstood subject, made worse by the assumptions academics made in coming up with their version of what risk is. Risk can be easily defined as the odds of not reaching a goal. But academics have defined risk as overall variance of returns. In other words what are the odds of you not getting a pre-determined return on your investment. But in addressing risk in that way it leaves out the critical factor, your goal. For most people, investing is a process through which they reach a point that they have income without having to be employed. Mostly people think in terms of “retirement” income. So the goal is not a particular rate of return, but an income during non-employment years.

Let’s see how this makes a difference in investing approaches. If reduced rate of return variation is important, then diversification becomes the strategy. It is easy to see that by owning many different investments, you can reduce the risk of losing money [and of making big gains]. Hence, financial planners sell their clients on diversification and ease of investing. The strategy becomes one of simply periodic purchasing of well-diversified investments with low costs. The goal is to get a more consistent return at the cost of losing the extremes. But what is missing is the real goal of retirement income.

So the end results are that this strategy fails at producing adequate income for the vast majority of people who employ the strategy.

If your goal is simply stated as retirement income, then your risk is not having enough income. Notice above, you can reach your goal of reduced risk through diversification and lower expenses, yet fail in your goal of retirement income. Instead of using the strategy [speaking the language] of risk as defined by academics, it makes more sense using the strategies and speaking the language that corresponds to your goal [retirement income].

So here is where the rubber meets the road. What is the language and strategies that work for your goal? First, you should always speak in terms of income. Rate of return is fine to evaluate individual investments or cash on cash or any other metric that helps compare individual investments, but you need to always think in terms of income. Diversification becomes diversification of income instead of owning multiple stocks or bonds. Taxes become important because it is the biggest drain of income. Variation of value becomes almost irrelevant, replaced by consistency in income. Risk becomes odd’s of lost income not variance of rate of return.

So what investment classes work best with our new language of risk? Well, obviously real estate. But also dividend oriented stocks. And, of course, Life Insurance policies. Diversification of income would dictate using at least 2 out of three of those strategies. Now here is the kicker of these three income-producing strategies. You can get professional guidance with minimum damage to potential income. In fact, one can easily argue that professional guidance will only improve future income.

Do yourself a favor. Whenever you are speaking to a financial advisor and they start to speak the language of risk, ask yourself if the risk they are talking about is the same risk you are worried about. If you are worried about retirement income and they aren’t talking directly to that, find yourself another advisor.

BawldGuy Here: First of all, this post is freakin’ brilliant in how it so clearly communicates. Read it a couple times and soak in the truisms.

I strongly prefer combining real estate with insurance, as it eliminates risk altogether on the insurance side, in addition to providing tax free income at retirement. Remember — it’s income we’re lookin’ for when we stop working. The rest is happy talk.

Speaking of retirement income — you might like this post — written today by yours truly.

Gimme a call, will ya? 619 889-7100 will find me. BawldOperator ready to serve you. Have a good one.

Related posts:

1. EIULs and Risk
2. Investment Physics Are As Inevitable As Gravity — Defy Both At Your Own Risk
3. Diversify – Or Playing Not To Lose
4. Investing Without A Purposeful Plan – Are You At Risk?
5. Investment Diversification – Father Of Mediocre Performance