Tuesday, September 7, 2010

Personal Financial Life Planning RISK (Part A) – Part III Setting A Personal Financial Life Goal

Man seeks certainty, permanence, and continuity yet there is no fruit unless one goes out on the limb

Before elaborating on rate of return or even risk adjusted rate of return, lets deal with the question of risk

The following are definitions or ‘risk’:

· A Four Letter Word
· A Game by Parker Brothers (also makers of Sorry)
· Downside Volatility (Fluctuation) (1)
· Hazard or Peril
· Loss of Capital/ Principle Loss
· Beta, Standard Deviation, R2 and other financial measures/metrics/standards (2)
· Types: interest rate, political, inflation, longevity, deflation, credit, liquidity, currency, market, getting caught with your spouse’s best friend, etc.
· Probability/chance
· Gambling
· Being Wrong according to your insignificant other/spouse (correction: this is not a definition of risk but certainty!)

From the perspective of ENOUGH, all the above definitions of risk, whether qualitative or quantitative, are incorrect.

RISK is whether you make the goal or not.

The rest is commentary (i.e. probability of making the goal, return on beta etc.)

At a gut level: RISK is the danger of not making the goal – the failure to achieve the goal causing negative consequences.

Translating this definition to the most common fear (spoken or unspoken): risk is the fear of outliving one’s resources at retirement (and thus being dependent & or beholden).

(When I was in practice, when prioritizing personal financial life goals with clients, it has been my experience that the ranking of income replacement upon disability initially is ranked very low. However, then I employed an exercise for reprioritization. On one side of the page, the client would put his personal financial goals on one side (i.e slow down, retirement, education for kids, income replacement upon disability, income adequacy for spouse upon either’s passing etc.) Then on the other side of the page, I would have then write next to each goal what they would LOSE if the goal was not achieved. In the case of income replacement upon disability, most would write ‘being dependent, being beholden’ and some ‘having to take from my kids.’ When each goal was translated into the underlying value, they would re-rank the goal with the value attached. The re prioritization upon re-ranking with values were typically significant with income replacement upon disability always rising!
Try this exercise – but don’t if you are just going to lie to yourself.)

As am precocious child, I would play checkers with my Poppi. Often, he would let me jump one of his checkers only to find out it was a set up for him to take three of mine.

It is risky to sacrifice (risk a goal) what you have for what you don’t have – unless it is to reach a higher priority goal. Otherwise, Poppi Schwartz is just setting you up.
Besides, in the end, the king and the pawn (or checkers) all go in the same box.

Now there is a distinction between risk and uncertainty. Though I prefer to define risk as the danger of not making the goal in relationship to uncertainty (and there is a difference), author Frank Knight, makes the following distinction: risk has an unknown outcome, but we know what the underlying outcome distribution (of outcomes/results) looks like. Uncertainty also implies an unknown outcome, and we don't know what the underlying distribution looks like.

Insurers accept the risks with exclusions, don’t insure certainty except death, and fight uncertainty trying to establish it was not covered by the policy.

The risk of making a goal can often be quantified and dealt with. But planning for uncertainty, the black swan, is highly doubtful. Of the 16 asset classes during the last financial meltdown, only one, treasuries, increased during the crash.
So why didn’t one market time? Well, the probability of successful market timing over time, studies have shown is less than .00000004 whatever amount of zeros. In the ‘90’s the Dow was up something like 16% per year but if you missed the top 15 or 20 days your annual rate of return was in the 5% area.
So risk is either we make the goal or not. The probability of achieving the goal will be dealt with in greater detail next week in Risk (Part B – Monte Carlo Analysis) Part III Setting A Personal Financial Life Goal

Insurance is the transference of risk (hazard in this context). In return for transferring the risk of a large loss, one pays premiums (a small loss). Thus one substitutes a small loss to avoid a large loss.
When we seek a rate of return, after tax, that is greater than necessary to make the goal taking on riskier assets (whether for external validation, locker room bravado material, a thrill down their Chris Matthews leg, or whatever), we are increasing the probability of not making the goal. In doing so, one in seeking More potentially is sacrificing Enough – which makes one a MOREon.
Sacrificing what you need for what you don’t need – now that’s Risky Business without Tom Cruise in white socks.

And Schwartz Poppi would call you a nudnick.

Risk of not making a goal is interactive with achievement or non achievement of other goals.

For example, for whatever reason, your retirement goal is not funded as of yet. However, due to health reasons and vocational reasons, you are unable to secure good disability coverage (or what I would prefer to call income replacement upon illness or accident due to partial or full disability to avoid capital depletion).
Without your earnings if disabled, there is no retirement goal funded to your desires.

Thus, you would have to self insure the risk to the goal (or find employment where there is disability insurance on a guaranteed issue basis – but let’s stipulate that that option, marrying rich, nor getting a large inheritance are out of the question as well as getting social security disability payments as you are merely partially disabled).

All of a sudden, the risk/probability of not making the income adequacy upon partial disability impacts the rate of return you may get for your retirement or slow down prior to retirement goal.


You may make the decision that you’ll need two to three years of cash flow that is not subject to the volatility/fluctuation of the stock market or illiquid assets you hold because you can’t transfer this partial disability risk through insurance.
The effect may be starting the retirement or slow down period later (decreasing the duration of those goals.)

The point is – the amount of the goal, the duration of the goal, and risk are once again all interrelated.
You pull on the string on the sleeve on the sweater and sometimes the neck bent out of shape..

And that’s what happens when you play chicken (more, more, more) with your goals.

(1) Fluctuation/volatility is confused with the risk as defined as loss of capital. Fluctuation isn’t loss of capital
(2) The problem with beta, standard deviation, r2 is they begin with a reference point instead of what worries the investor most

Next: Risk (Part B – Monte Carlo Analysis) Part III Setting A Personal Financial Life Goal

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