risk | Squirrelers

Is Being Risk-Averse Good or Bad for Your Finances?

What is your risk tolerance?

I’ve been giving some thought to the notion that we must take chances – or better yet, informed chances – in order to succeed sometimes. There are times when situations can offer potential benefits that make the risks worth taking.

Nevertheless, many of us have a low tolerance for risk that can manifest itself in many situations. Some examples of such situations are:

Investing conservatively instead of pursuing higher returns
Staying in our comfort zone instead of trying for a “stretch” job that pushes us and offers potential
Being afraid of speaking up with a novel idea, worried that we may be ridiculed instead if people don’t like our innovation

I also think that being risk-averse (side note: think of grammar and wealth, and PLEASE do not ever say “risk-ADverse”) is rooted in fear of loss or of some potentially negative consequence. It seems to me like a defense mechanism that many of us take on in order to protect ourselves.

Personally, my big financial motivation, deep down, is to avoid being really old and needing to work for money. Generally, we don’t get more energetic or healthier as we get older. I really don’t want to be struggling financially at an old age. Not that I am now, but the thought of things going bad is a something that helps light that fire of motivation to get me hustling. I know this might sound more defensive that aspirational, even though I clearly do have aspirations as well. However, this fear is probably the leading motivator, while not being the only one.

That being said, intellectually I believe something that rides a bit counter to that motivator. Intellectually, I think that a smart approach to handling finances and prioritizing time is to remember that we need to make money before we can save money. Why spend most of our personal finance efforts on pinching pennies, when the ROI on our time is often better when oriented toward income generation? That’ s not to say that saving money is a waste, because anybody who has read this blog and especially the squirreling gone wild series knows that I often celebrate extreme efforts to save. But, while we need to focus on making and saving, it’s the making money part that should get more time.

Do you see the dichotomy?

While on the one hand I am saying that it’s better to spend more time on income generation than on frugality, on the other hand my biggest motivator is fear-based: being old someday and not having enough money. That defensive primary motivator guides behaviors that support it, which are often risk-averse.

That brings me these questions:

Does risk-aversion harm one’s finances, or is it a good thing?
Is it more profitable over the long run to err on the side of being a risk taker, as opposed to being risk-averse?
How would you characterize yourself in this regard with money? Let’s use a 1-10 scale, where 1=very risk averse, and 10=having a very high tolerance for risk (or even seeking it out)

Managing Financial Risks: The Tricky Math Behind Losing Money

By Squirrelers 12 Comments

When we think of ways to build wealth, we often think of ways to make more money and spend less money. The more you make, and the less you spend, the more you keep.

Over time, that can accumulate into a solid foundation for retirement, and help us to grow net worth. However, we must also watch out for some financial pitfalls along the way, though proper risk management. One very basic way to do this is to simply avoid losing money. It’s basic, yet interesting how the math works: you get excessively punished over the long run when you lose money on an investment or other financial decision.

Here’s what I mean:

Let’s say you start with an investment of $10,000 in a company’s stock. Let’s say that company has some negative developments, and its future looks less rosy by the end of that year. Further, let’s assume that the stock drops 20%. This means that your $10,000 investment just fell to a value of $8,000.

Okay fine, not the end of the world, right? As we know, the stock market can be volatile, so if it goes down one year it might go up the next, right? Let’s say it goes back up 20% the following year. Does that cancel out the 20% loss from the prior year, to make us even?

No. A 20% increase from $8,000 puts us at $9,600. To get back to where we started, $10,000, the stock has to go up 25% in that second year.

If you lose money, it takes a larger percentage increase to catch up. Lose 20%, and you have to gain 25% to break even.

I think this basic concept speaks to the importance of managing financial risks, and making sure to avoid big financial losses.

Keep in mind that I’m not saying that one shouldn’t invest in the stock market. I’m simply using the stock example to illustrate how any investment or decision resulting in a loss can make our money have to work harder to get back to break even.

How can we avoid big losses while managing risks? Here are a few examples:

Buy index funds. You’re still buying stocks, but you’re diversifying risk compared to focusing on just one or a few stocks.
Get the right insurance. Home, car, and other insurance policies can help protect us in the event of disasters. Problems can and do happen, even if some are less likely than others.
Conduct good estate planning. In the event of an unfortunate passing, nobody wants their money to be given to somebody not deserving! Also, nobody wants to see fighting over an inheritance divided between siblings. While this is a different type of loss, its one most would want to avoid.
Do your homework. By this, I mean actually think about big purchases analytically and not just emotionally. For example, buying a home that is a good value versus buying a dream home based on emotion and not much else.
Watch out for scams. There are scams that happen all over the place, and it’s particularly tragic when it happens to unknowing seniors. Even those of us that aren’t of that age often face jokers who try to swindle us. Have you ever received one of those emails promising a financial windfall?

Bottom line is that once we lose money, it’s harder to get it back based on the math. Risks are a normal part of life and investing, but we should be sure to remember the downside and protect against it. We just might end up very thankful we did!

My Questions for You:

Do you ever think about how a certain percentage loss requires an even greater percentage gain just to get back to where you started?

Do you manage risks based on the 5 ways listed?

Are there any other suggestions you have for managing financial risks?

Are You as Internationally Diversified in Stocks as You Should Be?

By Squirrelers 4 Comments

As we manage our investments, many of us allocate our money across different classes: stocks, bonds, real estate, cash, and so on. Within stocks, many of us have different strategies. Some stick to index funds, some like individual stocks, some like a hybrid approach. We are all different.

But here’s a question for you: when you invest in stocks, do you first think of companies in your home country? For example, if you’re in the U.S., do you think of U.S.-based companies as the basis of your equity investments?

According to this interesting piece on Kiplinger.com, you may be guilty of home-country bias. This is where people tend to invest more in their home country stocks than they should based on percentages. For example, the article states that the U.S. owns 43% of the world’s stock market value, but U.S. investors hold 70% of stocks in American companies.

Interestingly, the are more glaring examples given. Japan holds about 10% of the worlds’ stock value, but Japanese investors focus 63% of their stock investments on home country companies. An even more extreme example from the past: in the 1980’s Sweden accounted for less than 1% of the world’s stock value, but Swedish investors – according to the article – were 100% invested in home country stocks.

To me, this is another example of people focusing too much on what they know, feeling safer about that than what they think they don’t know. This concept extends beyond the realm of domestic vs. international stocks, all the way to people investing in their employer’s stocks vs. other stocks because it’s the home team.

I have clearly seen this phenomenon in action, in one particular case from years ago, where I heard someone announce to a large gathering of coworkers at his retirement party, that he invested 100% in the company and that he recommends that we all do the same. I couldn’t believe my ears – not only by the words he said, but also by the ovation he received from much of the attendees.

Whether it’s your own employer, it’s industry, or your even home country – it’s smart to watch out for this familiarity bias.

As for myself, I have employed an index-based strategy for the most part, so I’m not showing a familiarity bias in terms of companies or industries that I personally know better. That said, I have to say that after looking at the figure above referencing the U.S. holding 43% of world stock value, I have to say that I too have shown a home country bias. I have been down in the 10% range, in terms of percentage of stocks that are international. To me, this has been something I thought about as a way to have some diversification, but I still thought of U.S. stocks as the obvious foundation of my stock investments.

As I think about this more, it may time for a paradigm shift for me. This might mean thinking globally first while leaning toward home country stocks out of loyalty, vs. what I have been doing, which is thinking U.S. stocks first and foremost with international stocks just as a token part of my investments.

What do you think? Do you have a home country bias with your investments?

Should You Have a Safe Deposit Box?

By Squirrelers 6 Comments

We all have important documents, and most of us have at least a few sentimental items, that we absolutely want to keep safe. Sure, we want to keep most of our things intact, but there are few items that require special care. To that end, we want to keep them in a safe place.

To keep key valuables safe and secure, one option some people take is to rent a safe deposit box. Some people like this practice and swear by it, and others don’t like the idea of keeping valuables outside of their immediate possession. Let’s explore the question: should you have a safe deposit box?

What are the reasons to have your valuables in a bank safe deposit box, as opposed to at home, where they are in close proximity to you, in a place where you feel you can keep an eye on things? Here are several:

Your bank’s vault is more secure vs thieves. If you have a safe deposit box, you will generally have to show your picture ID, be authorized to access the box, sign in, have the specific key for your box with you, and be accompanied to the locked, secure room by a bank associate – all while being on camera. That’s a more rigorous defense system for your valuables that someone coming into your home.
Thieves can probably figure out where you keep your valuables. Do you keep your valuables in your master bedroom closet? Perhaps in a safe? Under your bed? Maybe in your den? Crooks can figure out how we think, and where we are most likely to keep important things. We all hear news accounts of dumb criminals, but realistically, if the bad guys want to find your stuff, they probably can.
Your safe can be carried out. If you keep a safe somewhere in your home, unless it’s incredibly heavy or very securely attached to your home, home intruders can figure out a way to take it.
A safe deposit box is more secure vs fire and water than your home. Think about it – the safe deposit box is constructed securely, and is housed in a vault that’s constructed to be solid. Is your place of residence constructed that safely?
Insurance premiums. Some companies may charge lower premiums on items kept in a bank safe deposit box vs being kept at home.

There are also negatives to getting a safe deposit box:

In an emergency, safe deposit boxes are less accessible. If you need a passport for overseas travel, power of attorney documents, and other items that you might need in a hurry. Remember, the box will likely be accessible only during your bank’s normal hours. And many of us have heard the term “banker’s hours”, so we know what that can mean.
Contents are not FDIC insured.If you have financial assets, and they are not held in accounts in the bank but are simply in a safe deposit box, they are not FDIC insured if they are damaged or stolen.
Safe deposit boxes cost money. These can range in cost depending on size, but typically cost at least $50 to $100 annually. Often, these costs can go much higher.
Could be declared “abandoned”. This depends on laws on a state by state basis, but if you don’t pay your rental fees for an extended period of time, the contents may be declared abandoned and turned over to the state’s unclaimed property office. If you’re not careful, or lose sight of this administratively, you could be in for some hassles.
Items are not in your immediate possession. For many of us, there is a sense of security, or peace of mind, knowing that our valuable are actually with us. At some level, maybe in our subconscious, we have it in us to be like little children when it comes our stuff – it’s MINE! Additionally, sometimes we might want to look at or show certain valuables, such or jewelery, collectibles, etc.

Personally, after weighing the positives as well as the drawbacks of a safe deposit box, and considering the alternatives, I rented one for myself and recommend safe deposit boxes.

Now, it’s not as convenient as having important documents and valuables at home, and the accessibility aspect has caused me some hassles. For example, I recently needed a document during the work week, but needed to wait until the weekend to access it. Fortunately, it didn’t cause me problems in the end, but it could have. However, despite those types of drawbacks, I feel that certain important documents and valuables are safer in my safe deposit box than in my home, even though I live in a safe area. To me, safety and risk management is more important than convenience.

Tip: whether you keep papers or other valuables in a safe deposit box or at home, keep them in a sealable, airtight, water-resistant container. For example, a large ziplock bag. This helps minimize potential damage from any water damage.

What about you? What are your thoughts on safe deposit boxes as a way to store valuables?

This post was included in the Carnival of Personal Finance at Personal Finance Journey.

Diversification vs. Investing in What You Know

By Squirrelers 5 Comments

Earlier in my career, I attended a big going away celebration for someone who was an executive at the company for which I worked at the time. I had just joined the company, and didn’t know this gentleman or his history at the company. Yet, I went to this event along with most in my department and several other closely related departments.

I can remember the scene – it was in a large auditorium-style meeting room, and there were probably at least 200 or so people in the room. The guest of honor, who was retiring, gave a speech where he recalled his proudest accomplishments at the company, shared lessons he learned along the way, thanked people who helped him achieve his success, and told a few short, funny stories. It was clear that people liked him, and that he was respected, judging by the reaction of the attendees.

Toward the end of the meeting, the guy got serious and said that he was going to share his best advice for all of us, based on his experience, that would most benefit each of us personally. The room got a bit quiet – funny how that’s the case, when the notion of individual benefits is mentioned:) Then, he told us that his best move for his family was the confidence he had in his employer, and his loyalty to it. And how did he show that? He proudly proclaimed that he took his personal investments and put it directly in the company stock. Not just some – but ALL. Yes, he invested everything he saved from his job in his company stock. He proudly, emphatically recommended that all of us do the same, and that along with our hard work will give us the same type of rewards.

Instantly, almost as if on cue, the majority of the people rose up and gave him an ovation. Heads were nodding up and down, and he was clearly seen as the loyal, good soldier who made out well. That latter part may have been the case, but not all of us gave him an ovation. Some of us – including myself and the lady next to me – were stunned and just sat there shaking our heads.

Now, I was of course happy to see someone successfully ride off into the sunset amid great fanfare and financial success. Good for him. But his advice to the crowd was flat out wrong.

He suggested putting all your eggs in one basket – the one you know best and are most closely tied to. To him, his actions were smart and honorable. To me, his actions were well-intentioned, but naive and lucky. Very Lucky.

The stock performed well over the years, increasing significantly over the time he worked there and would have made his investments. So I can see how he feels like he hit a home run – because he probably did, and I’m guessing it went way out of the park! That said, what if he took the same approach, out of loyalty, to a different employer. Let’s say that company’s stock ended up tanking. Anyone remember Enron? There were plenty of people whose personal finances were just torched by that episode.

It just doesn’t make sense to tie up a large percentage – let alone all – of one’s equity investment in one stock, out of loyalty or otherwise. Additionally, when that company also happens to be your employer, you are taking an even riskier strategy, as even more of your personal situation is directly tied to one investment.

I see how the logic could be appealing – invest in something you know very well, as opposed to investing in a wide variety of companies of which you know very little. Knowledge is better than no knowledge, it should seem.

In the case of your the equity portion of your portfolio, however, don’t invest it all in what you do know very well – your long-time employer – but invest in a diverse portfolio of companies. Index funds fit this strategy very well. Yes, I’m saying choose what you don’t know as opposed to what you do know!

Putting it all in what you know, to those that do it, seems safe. In reality, it’s a tremendous risk, in my opinion.

What’s your take? Do you feel safer by diversifying through investing in companies you may not know (index funds), or by focusing on a company that you know extremely well (employer or former employer)?

Remember Rule #1 – Don’t Lose Money

By Squirrelers 2 Comments

Sure, none of us want to lose money. That’s no fun! Making money and growing our investments is what we look to do. When you look at the math, its more important than we might think.

The world reknowned super investor Warren Buffet has even been paraphrased as indicating: Rule #1: Never Lose Money. Rule #2: Don’t forget Rule #1.

Sure, we have to take risks at times. It is a part of being an investor, and there is a risk/reward dimension that frames many of our choices with our finances. It even frames choices in our life too. But as a personal investor, its important to manage your portfolio with some simple math in mind.

And it really is quite simple, conceptually.

Here is a classic example:

Scenario 1: You have $100, but lose 10% in year one and gain 10% in year two. This means that after year one you have $90, and after year two you have $99.

Scenario 2: You have $100, but lose 20% in year one and gain 20% in year two. This means that after year one you have $80, and after year two you have $96.

Think about it.

When you look at both Scenario 1 and Scenario 2, its clear that once you lose money from a certain base amount, gaining the same percentage back on the new base won’t get you back to where you originally started. This is where losses in your portfolio – be it equity or real estate – can really wreak havoc with your overall financial situation. It might not be evident a the time, but it puts us behind the 8 ball, so to speak, when we lose money.

To further illustrate this, lets focus again on Scenario 2. With a 20% decline from $100, you’re then at $80. To get back to $100, you need to have a 25% increase in the following year. Again, showing that once you lose a certain percentage of money, you need to increase it at a higher percentage to get back to where you started. This can be a challenge; a 5 percentage point difference is fairly significant, all things considered.

An additional point to consider when looking at Scenario 1 and Scenario 2: look at where you end up in Scenario 2 vs. the first Scenario. In Scenario 2, since the percentages were higher, you end up at a lower amount after year 2. Thus, the bigger the loss, the harder it is to recover.

The takeaway from this as it applies to our investments is to carefully manage risks. Losing money puts you on a slippery slope when it comes to getting back to your starting point.

A further takeaway from this concept, taking it further, is that money can be hard to come by. Keep your earning power by having marketable skills, and live within your means by embracing sensible frugality. This puts you in a position to recover in other ways if your portfolio takes a hit.