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How to think about risk in financial planning

(MoneyWatch) Bloomberg's Pimm Fox recently asked me how investors should think about risk. He wasn't referring to your portfolio going up and down. Instead, he meant how you address the outside factors that could derail your plan, even if your returns are better than you were anticipating. Here's how you should think about those outside factors.

Investment gains and losses. Before we get into the other types of risk, let's have a quick review of the risk of gains and losses. When talking about your portfolio, there are two types of risk:

  • Good risk, for which you're compensated through higher expected returns
  • Bad risk, for which you receive no compensation for taking

For example, stocks are riskier than bonds. No matter how many stocks you own, you can't diversify away their risks. Because of this, stocks have to offer higher expected returns than bonds. Otherwise, investors would only invest in bonds. Why else would you take on risk if you weren't expected to be paid for it? This is good risk, the kind you're paid to take.

Bad risk, on the other hand, means doing something like concentrating all your stock positions in a single sector or country (including your home country). Economic and geopolitical risks can be diversified by building a globally diversified portfolio. Since you don't receive higher expected returns for concentrating your risk in a single country, why wouldn't you diversify that risk?

Longevity risk. Simply developing your investment plan isn't enough to ensure that you'll have enough money to fulfill all your financial wishes. For example, you run the risk of outliving your assets. Thus, while investing in stocks means you might lose money, not having a high enough allocation to stocks will likely increase the risk of not achieving your financial goals -- including not outliving your financial assets. Annuities are also a way to hedge against this risk, provided they're properly structured for your situation.

Liquidity risk. There are many investments that have higher expected returns because they're less liquid, meaning they can't be traded or cashed in as easily as, say, Treasury bonds. It can also mean that trading them means you'll incur greater costs. This doesn't mean holding them is necessarily a bad thing, but you need to prepare in case you have a sudden need to raise cash. Do you have access to other assets in case of emergencies? If not, you may be forced to sell your illiquid assets at steep costs. Investors should make sure their plan addresses the potential for unexpected calls on liquidity -- keeping sufficient assets in very high quality, short-term bonds.

Inflation risk. People living on fixed incomes are at a significant risk of inflation. If the prices of goods rise dramatically and their incomes don't, they then face difficult decisions to make about what gets cut out of their budgets. Those with significant exposure to this risk, such as retirees, should favor bond investments that are linked to inflation (Treasury inflation-protected securities and I bonds) and/or they should favor short-term nominal bonds. They might also consider an allocation to commodities, which tend to perform well when inflation is rising.

Life event risk. Insurance becomes an important part of the equation as well. Your investment plan isn't worth much if daily life throws you a few curveballs you aren't prepared to handle. A well-developed financial plan includes a detailed analysis of the need for protection against various risks:

  • Life insurance, for replacing income lost with the death of a breadwinner
  • Disability insurance, in case a breadwinner can't work
  • Long-term care insurance, to protect against care costs draining your assets
  • Property and casualty insurance, such as for homes, cars and boats, and against floods and earthquakes
  • Personal liability insurance, including an umbrella (excess liability) policy

The bottom line is that to develop a well thought out financial plan, it's critical to consider all of the various risks that could derail it.

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