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What is Estate Planning and How Can it Help Me?

An estate is composed of everything the individual has rights to. This can include property, business interests, investments, joint ownership, life insurance owned by the individual (and those gifted within three years of death), retirement benefits, possessions, and any other personal assets.

An estate plan can be thought of as a portal. When an individual passes away, all of their assets must pass through this portal. First they will pass through the probate or non-probate filter. They will then pass through multiple other filters (the non-probate journey being much shorter) before the remainder finally reaches the desired individual or entity. [Read more…] about What is Estate Planning and How Can it Help Me?

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Importance of Understanding Risk When Investing

Accepting risk is acknowledging the possibility of losing some or all of the investment principal.  High risk typically means high volatility. When something is high in volatility, it is unpredictably irresolute. Both timing and degree of fluctuation are difficult to anticipate. When something is low in volatility its movements are predictable with a high degree of certainty, it is low risk.

Risk is not independent and should not be considered in a vacuum. Risk generally correlates positively with return. This means that as risk increases, so do potential returns. Unlike other risks we accept, there is no such thing as investment insurance to protect against bad investments.

When considering risk you must weigh the possible gains vs. the possible losses. The degree of risk that someone is willing to accept depends on a number of factors. One is simply personal preference. How much risk can be comfortably tolerated? A second is investment goal: Growth? Capital preservation? Income? A third is time horizon: how much time is there until the funds are required? High risk investments tend to do well over the long-term because time has a way of taming risk. Low risk investments do well in the short-term because they are more predictable and sometimes more liquid. There are many factors in determining acceptable risk; most of them tend to overlap.

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Averse to Risk? Most of us Are

Risk aversion is a trait common to most individuals.  This is why we buy insurance.  Most people must be compensated for accepting additional risk. This is why investors demand higher returns on riskier investments.  A risk averse person must be compensated for accepting additional risk even if the expected value is the same.  A risk neutral person only cares about expected value. [Read more…] about Averse to Risk? Most of us Are

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How Much Does Risk Cost? It’s too Expensive to Ignore

Risk is expensive. Most people are risk averse.  Both people and companies must be compensated in some way for accepting more risk. This is why individuals with poor driving records pay more for insurance and investors require higher returns on riskier investments.

The expense of managing risk is directly correlated with the expected losses.  Expected losses can be determined by multiplying the severity (cost) by the frequency. [Read more…] about How Much Does Risk Cost? It’s too Expensive to Ignore

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What are the Steps in Managing Risk?

With financial planning our goal is to minimize the cost of risk. Our primary tool in minimizing this cost is insurance, which transfers risk in exchange for payment (a premium). Insurance is all about managing risk, but how is risk managed?  There are three steps in this process.

Step One: Identify the risk.

What is the source of this risk?  What are the characteristics?  What is the expected frequency and severity?  Remember that expected cost = frequency x severity.

Step Two: How much risk am I willing to accept?

Financial considerations are typically the primary factor; how much risk can you afford to accept?

Step Three: How should the remaining risk, the risk that I am not willing to accept, be managed?

How much will each form of risk management cost?  Which is most cost-effective?  Determine the best way to deal with the remaining risk and monitor the success.  Make adjustments if necessary.

While the above are not hard and fast rules since every situation is different, they provide a general idea.

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Ways of Managing Risk

There are four main ways to manage risk: risk avoidance, risk transfer, risk reduction and risk retention. Each is applicable under different circumstances. Some ways of managing risk fall into multiple categories. Multiple ways of managing risk are often utilized simultaneously.

Risk Avoidance (elimination of risk)

Completely avoiding an activity that poses a potential risk. While attractive, this is not always practical. By avoiding risk we forfeit potential gains, be it in life, in business or in with investments.

Risk Transfer (insuring against risk)

Most commonly, this is to buy an insurance policy. The risk is transferred to a third-party entity (in most cases an insurance company). To be more clear, the financial risk is transferred to a third-party. For example, a homeowner’s insurance policy does not transfer the risk of a house fire to the insurance company, it only transfers the financial risk. A house fire is still just as likely as before. Risk sharing is also a type of risk transfer. For example, members assume a smaller amount of risk by transferring and sharing the remainder of risk with the group.

Risk Reduction (mitigating risk)

This is the idea of reducing the extent or possibility of a loss. This can be done by increasing precautions or limiting the amount of risky activity. For example, installing a security alarm, smoke detectors, wearing a seat belt or wearing a helmet are ways of employing risk reduction. Diversification of assets and hedging are forms of risk reduction with investments. Investments in information are a way of mitigating risk because you are better informed, thus reducing the uncertainty. Another way of employing risk reduction is the safety in numbers approach. When discussing risk transfer, we spoke briefly about risk sharing. The larger the number of people sharing risk, the less severe the shared effects will be. Statistically, only a small number of individuals in the group will experience an unfortunate event. Insurance companies exist based on this concept.

Risk Retention (accepting risk)

Risk retention simply involves accepting the risk. Even if the risk is mitigated, if it is not avoided or transferred, it is retained. Retention is effective for small risks that do not pose any significant financial threat. The financial status of the family or individual will determine the acceptability of a risk. A couple of examples of risk retention: A billionaire may not have to worry about insuring his car. An individual may not be able to afford or obtain health insurance. Both individuals are retaining risk, one is because they’re able to, the other is because they have to.  Risk retention augments risk transfer through  deductibles.  With a deductible, we retain or ‘self-insure’ small, frequent occurrences and only utilize insurance for needs over a particular dollar threshold, our deductible limit.