There are many types of risk that exist in financial planning. In the process of Financial Planning we must become aware of the risks, and incorporate their mitigation into our plan. We tailor strategies to each individuals’ risk tolerance, exposure, and life situation. Below are a few of the major risks that we take into account.
The stock market goes up and down with a number of factors including the economy, consumer and investor expectations, interest rates, inflation, and government policy. One major strategy for mitigating market risk is diversification amongst different investments. Having some basic consumer necessities protects us when the economy may be heading down. Entertainment and durable goods tend to do better in upbeat economies. Having some of each in a portfolio helps us ride out the different waves in the economy. Another type of diversification takes into account the global markets where some monies are invested in different economies such as Japan, Europe, and Asia. The idea is to have investments that correlate as little as possible with each other to increase the level of diversification, and therefore safety, in a portfolio. It can be challenging to accomplish this as every market correlates with others to some degree.
Business risk is the risks associated with an individual business. When you hold stocks or equity shares in a specific company, there are risks associated with it staying a viable concern. Competition from others in the same business, as well as new technology that may enter and change the business landscape are risks that any company faces. Diversification among many different companies and in different markets mitigates this risk. It is important to examine one’s portfolio to ensure that there is sufficient diversification. This is especially important for people who work at companies that may provide stock as part of employee compensation or deferred compensation. An Employee Stock Ownership Plan is one such plan that companies provide that is largely made up of a single stock. This must be carefully dealt with.
Interest Rate Risk:
Like the stock market, interest rates go up and down and the bond markets rise and fall in an inverse* relationship with them. While common wisdom in financial planning circles is that bonds are the safe haven from the stock market, because interest rates are currently at or near at all time lows this is no longer advisable. This makes finding safe havens for assets all the more challenging.
*For example, a bond may offer a 5% fixed interest rate (a $1,000 bond will pay 5% or $50 per year in interest). Interest rates rise to 6%. So a new bond would pay $60 rather than $50. If you wanted to sell your 5% bond, in order to be competitive it would have to pay 6% or nobody would buy it. So what happens is the price is dropped to approximately $833.33. A $50 payment on a bond worth $833 would be 6%. This is a simplified example. In actuality, because bonds vary greatly in their term, the amount of the discount will vary differently on each one.
Inflation is here to stay. It rises and falls depending on economic circumstances of supply and demand, government policies to support the economy, and seasonal cycles. One thing is for sure: If you’re planning a big-ticket item down the line, chances are good the costs will be significantly higher for the same goods as they are today. In order to reduce this risk, it is important to have your assets growing at least as fast as inflation. Otherwise, the spending power of your dollars deteriorates.
We all know what tax rates are right now and we know what our current situation is. However, as time goes by there are various risks involved. For instance, government may raise tax rates. The more money that one has in tax deferred accounts (401k, 403b, IRA, SEP IRA, etc), the more money that is subject to tax risk. Just as the stock and bond markets rise and fall, taxes move up and down as well, but much more slowly. At this writing, we are at near all time lows in our federal income tax rates. This, plus the level of the national deficit relative to GDP may mean that tax rates may need to rise sooner or later.
Mortality risk is the risk of dying at any given time. Morbidity is the risk of getting ill. Both of these are very real. Many employers cover their employees with a certain amount of health insurance, disability insurance, and even life insurance. Some offer none or very little. Often, the amount of coverage falls significantly short of what the employees need, especially with respect to life and disability coverages. People who are self-employed, work for small companies, retired or unemployed may need to address these risks on their own. Most employers do NOT offer Long-Term Care insurance at all. There are government programs that exist to help with some of these risks, though in most cases those programs a) may not be available to everyone in the population, and b) are quite insufficient to cover the risk entirely. In constructing a plan, we take all of these risks into account and do what we can to ensure adequate protection is in place.