Tag Archive | "risk"

Determining your Return and Risk objectives when investing

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Determining your Return and Risk objectives when investing

Money and Investing

Ask yourself, “Are my investments working to meet my financial goals and needs for each stage of life?” If you can’t easily say yes, then maybe it’s time to re-evaluate or create a written investment plan.

Why you need a written investment plan

One of the first steps to creating a personalized investment portfolio is setting return objectives and risk tolerances for each stage of life.

Let me give you an example. As a young college grad, you may be fairly risk adverse and willing to target higher returns and therefore higher risk. However, as you enter retirement, your return objectives are much lower and therefore your risk is much lower.

This principle is straightforward, but many investors don’t take the time to define their financial goals, return objectives, and risk tolerances for each life stage. The danger in not setting these objectives early is that (1) you can’t know if your investments are working to achieve your goals if you have never clearly defined what your goals are and (2) you may design a portfolio that exposes you to the wrong level of risk (could be either too little or too much risk).

So how many stages of life should you plan for? 

You need to identify stages that entail unique financial requirements and goals. The average investor will have two life stages: earnings and retirement (though you many have others like semi-retirement). For each stage, you need to determine:

  • The time period it will span
  • Your age at the beginning
  • What your life goals are
  • Your financial needs to meet your goals
  • And the financial instruments that are most likely to help you reach those goals

Setting portfolio objectives and structure

What’s your return objectives and portfolio structure for each life stage? This may seem like a straight forward question but truly poses many complexities.

First, identify the inflation adjusted amount of money that you need to have at the end of each life stage. For example, at the end of the earnings stage, I know that I’d like to have enough money in the bank to create an annual income of $50,000 in today’s dollars to live on each year.

The specific amount you use is up to you to determine.

There are many great calculators online to help you to figure out how much money you will need online.

Second, for each identified life stage you need to determine the necessary rate of return on the amount of money you will be investing to reach your goals.

This si when a good handheld financial calculator comes in handy. Basically, you enter the amount of money you need at the beginning of a specific life stage (such as retirement), how many years between now and then, and your annual contributions.

The calculator will then spit out the rate of return that you need.

Remember that your rate of return is an average rate of return. For example, let’s say you need 8% each year. You can earn 0% one year and 16% the next year and that’s still 8% over the two years.

So don’t freak out if one year underperforms.

What’s your risk tolerance and benchmark indices?

Knowing how much you need to retire and the rate you need to earn will help you determine just how risk adverse or risk tolerant you need to be.

Just to be clear, risk does not mean anything negative. Risk is just the measure of a specific outcome, both good and bad.

If you need a high rate of return to achieve your financial objectives, then you have two options. First, increase the amount you are saving, which you should do anyways. And second, take on investments with higher risk.

Emotionally, many people can’t take on much risk. That means you are stuck with option #1 – invest more money. But if you can stomach it, then you should carefully evaluate higher risk investments.

Caveat – Don’t do anything stupid just because it’s promising big money.

As time passes, you will want/need to evaluate how your portfolio of investments is progressing. For that reason, select benchmark indices as a basis for comparison.

Example: If I’m investing in a bunch of large cap mutual funds, then I should compare my return to the S&P 500. But if I’m investing in small cap funds, then I should look at the S&P SmallCap 600.

This is just the start

A lot of work and research goes into creating a sound portfolio. But hopefully, this post gives you an idea of where you need to start.

If you have any questions, definitely consult a certified professional.

For everything else, follow Rabbit Funds on Twitter.

(This post was featured in the Carnival of Personal Finance hosted at Money Q&A)

Posted in Investing, Planning, RetirementComments (1)

Auto Insurance: 3 Things You Should Know

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Auto Insurance: 3 Things You Should Know

While I was attending college, we had a visiting lecturer for my financial planning course who discussed the various types of insurance. In particular, he gave us a crash course on auto insurance.

Driving KeysI was astounded by how little we all actual knew about our own auto insurance. It’s like that commercial from awhile back where a lady asks various random people, “What should my deductible be? $500? $1000?” Not fully understanding is a problem common to many financial instruments…unfortunately.

#1 Let’s start with the basics – Risk

At it’s heart, insurance is the transfer of risk. For example, I have a wife and two kids. I know that they are going to get sick several times a year. Instead of bearing the “chance” of a financial crisis because I can’t pay the medical bills, I transfer that chance to a health insurance company in the form of premiums. In other words, I pay them to take the chance that our medical bills become really expensive. At the same time though, the health insurance company is taking the chance that my medical bills will be really low. So, don’t think of risk as being a negative thing – it’s not. Risk is just the probability that a certain outcome, both positive or negative, will occur.

In terms of auto insurance, you need to determine how much “risk” you want to transfer. Take a moment to evaluate your financial situation. Can you afford $1000 worth of damages to your car? Hopefully the answer to that question is yes since you have at least $1000 in an emergency fund.

#2 Accident lawyers are always smiling for a reason – Insufficient Coverage

Have you ever seen an ad for an accident law firm where every lawyer is not smiling ear to ear? Do you know why they smile from ear to ear? Because they make so much money from accident settlements. So they don’t care what your situation is. They are coming for you if you cause an accident.

So how much risk do you want? In my state, the required minimum coverage is 25,000 / 50,000 / 50,000. It’s very important that you understand what those numbers mean and how they can ruin your life. If I have 25k / 50k / 50k, then my insurance company will pay out up to $25k to any one individual in a car accident that I cause with a maximum payout of $50k. And the maximum property payout is also $50k. So really read those numbers as: Maximum Individual Payout / Maximum Total Payout / Maximum Property Damage Payout.

To help illustrate the amount of “risk” that I would be baring, I’m going to use several scenarios.

Scenario 1

I hit a minivan with five scouts in it and they all spend three days in the hospital. A three day stay will probably run about $10k each. So I now owe $50k in medical bills. Of course, that doesn’t cover the minivan damage itself – estimated at $30k. So my auto insurance fortunately covered the medical bills but I am still left with a $30k bill for the minivan.

Scenario 2

Let’s say that I don’t even hurt anyone, but I happen to hit a 2011 Cadillac Escalade. MSRP starts at $62,495 on a new Escalade and I just totaled one. My insurance company pays out $50k and I’m left owing $12k+. Personally, I don’t have that much under my mattress.

Scenario 3

You cause an accident involving three average cars and four people take a trip to the hospital. I could do the math, but I bet you get the point. It’s very easy to rack up a large bill even in a simply accident.

But I’m just a college kid, they won’t come after me.

Oh yes they will!

Attorneys will not only consider your current financial situation but also your future earning power. If you are a college kid who will be graduating with a good degree, then they expect that you’ll be making decent money in the years to come. So they will have the court garnish your wages. Meaning, you’ll end up paying for years.

More coverage is pretty inexpensive

Assuming you don’t have a terrible record, auto insurance is very inexpensive. For example, after learning all of this myself, we changed our coverage to $250k / $500k / $500k for an extra $9 a month. Meaning, I can sleep a lot easier for only $9 a month. I want more things like this in life.

#3 Always kill Bambi – Acts of God

Please no one tell my two year old I said that. Imagine for a moment, though, that you are driving down the road and a deer jumps out in front of you. You of course swerve to miss it and crash into the barricade or a tree. As far as the insurance company is concerned, the collision was your fault. However, if you hit the deer, then that was an Act of God and you are not responsible.

Not being responsible will matter when you renew your insurance. If you now have an accident on your record where you were found at fault, then your rates will increase. So no offense to anyone, but always kill Bambi.

There is a lot more to purchasing the right insurance policy, but hopefully this brief overview gives you a good starting point for evaluating your current coverage. For more information on financial planning topics, sign up for our RSS Feed and receive new posts directly in your favorite RSS reader.

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The number one thing you should consider when investing

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The number one thing you should consider when investing

InvestingMy wife and I learned this lesson the hard way. Some time ago, we had the opportunity to make an investment in a start-up company that was hoping to go public. After considerable deliberation and time, we decided to go ahead and invest an amount that we were comfortable losing (at least that’s what we thought at the time). The promise of a big payoff was just too good to pass up. Within months, the company went bankrupt and we lost everything that we had invested.

I wasn’t sure what to take away from this experience until I was listening to a Goldman Sachs investment banker during a lecture series on financial planning. He asked the audience midway through his lecture, “What is the number one thing that you should consider when making an investment?” A few dozen hands went up and one student responded, “The return.” To our surprise, our lecturer said, “No.” Everyone’s hand went down. After coaxing us for a few more minutes, someone finally ventured, “Liquidity.” Again to our surprise, our lecturer said, “Bingo, that’s it.” He went on to tell us of an investment that he and his wife had made in the movie The Other Side of Heaven and how they had lost everything. The real kicker was that as they realized that the investment was beginning to slip away, there was nothing they could do to recuperate any portion of their money.

At that moment, I realized that the lesson I needed to learn from our attempt at a small fortune was that we should not make investments where we had no means to recuperate our money even if it was at a loss. We have since added an additional rule to our investment guide – every investment must offer liquidity. The average family does not need to take on that much risk. Although the opportunity for gain may be large, the financial risk associated with non-liquid investments outweighs the potential return. Don’t let greed get the best of you or your money. Had the investment that we made had some option to sell our shares, then we could have minimized our loss. However since we could not sell or transfer our shares, we lost everything.

There are many factors to consider when making an investment and maybe liquidity isn’t the leading one. However, make sure that you have an out, even if that out means at a loss, before investing your hard earned money. If you have no out, then there is probably somewhere better to put your money.

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