Unfortunately, the nomenclature for most typical asset accumulation ground rules/ constraints is the word ‘risk’ and secondarily a description of what the asset provides. (As to the latter, there is only so much juice in an orange – which will be the metaphor relative to these factors in the discussion of retrofitting.
“Risk Ground Rules”
Per previous entries, I have defined risk as ‘not making the goal – the chance of not making the goal.’ That said the following considerations, which are either “prone” or “offset” in part or in total depending upon your defined parameters – become a basis for ground rules and are typically referred to in terms of risk:
· Inflation or Deflation Risk – fluctuation in purchasing power of assets and or income is a function of inflation or deflation. For example, in general, cash’s purchasing power is eroded in inflation while increases in purchasing power in deflation
· Systemic Risk - occurs when the failure of one party to meet a financial obligation causes others to also not be able to meet obligations. For example, a person who purchase a home for investment purposes may depend on rental income to make the mortgage payments. If the tenant is unable to pay the rent, the home owner in turn may not be able to make the mortgage payment. A more recent example: you pay make your mortgage month in and month out, year in and year out, and you wind up paying your deadbeat neighbor’s mortgage through government bailout due to Barney Frank, Chris Dodds, Andrew Cuomo and Bill Clinton’s Fannie Mae& Fredie Mac policies making renters into owners who could not afford the mortgage and default impacting the value of your house as well!
· Interest Rate Risk – the value of an investment goes up or down with interest rate changes. For example, there is an inverse relationship of bonds to interest rates. When interest rates go down, bonds typically go up and vice versa.
· Liquidity Risk – the potential that one will not be able to sell the investment quickly enough or in sufficient quantities because of selling options are limited often resulting in a dimunition of value of the investment at the time. See forced sale.
· Market Risk – market risk exposes our intangible assets (stocks, bonds, and alternative investments trades as stocks) to the fluctuation of the market and potential capital depletion or appreciation
· Market Timing Risk – attempting to time market movements, investors ‘risk’ being out of the best markets and going into the worst markets
· Reinvestment Risk – that risk that market interest rates/dividend rates have decreased at the time payments/dividends/interest from an investment are received. The investor will be forced to reinvest his or her payment amount at a time when rates are not as favorable as they may have been previously
· Repayment (Credit) Risk – chance that a borrower will not repay an obligation
· Monetary Risk – the value of currency declining
· Political Risk – the possibility of nationalization or other unfavorable governmental actions or Obama being reelected.
· Longevity Risk (A BIGGIE OFTEN IGNORED BY PLANNERS BUT FEARED BY CLIENTS WHETHER THAN KNOW THE NOMENCLATURE OR NOT – the fear of outliving one’s resources.
· Divorce Risk – the up to 50% risk of first marriage dissolution, and 70% of second marriages dissolution causing capital depletion (see previous section on asset protection)
Offsets & Prone
I’d advise you to make three spread sheets consisting per each objective the assets dedicated to the objective running down the column vertically and across two columns for each risk – the amount of the asset ‘prone’ (to that risk), and the adjacent column ‘offseting’ amount (if applicable). For example, the amount of a $200,000 position in intermediate bonds prone to interest rate risk may be $200,000 with no offset. However, the same $200,000 invested in short term bonds (1-2 years) one might say is but $100,000. Relative to deflation risk, the same $200,000 in intermediate bonds (assuming high quality) might be put in as $200,000 offsetting deflation risk whereas if the intermediate bonds were junk quality – maybe the number is $50,000. The net effect, inflation risk – prone versus offset should be divided by the total value of the objective’s portfolio value as a percentage. This analysis should be run three times:
· First baseline relative to each risk if you do nothing per the objective
· Second, what the prone to offset should look like ideally
· Third, after you retrofit your portfolio per objective what each risk would look like (prone to offset) to make tradeoffs between the requirements of the goal and you concern for the risk –prone/offset ratio.
Next: Ground Rules & Constraints – Asset Accumulation: Part II Retrofitting
(The Tease: Most people’s portfolios consist of what they have been sold – not what they have bought)