Posted February 2010 – John Spitzer
Managing your risk constitutes a major element of your financial plan. In this section, we discuss two broad areas: managing insurable risks (such as your life and home) and managing investment risk (the variability of returns on your investments).
Managing Insurable Risks
You can buy insurance for all kinds of things: to replace lost earnings in the event of premature death (life insurance), to cover the costs of damage to your home (homeowners insurance), automobile (car insurance), or even your newly-purchased television or electronics gadget (what we call gadget insurance). Health insurance constitutes an important part of our insurance, but the complexity of that field precludes us from covering it here.
From a finance standpoint, the steps in managing these risks are straightforward:
- Identify the risk – in common words, what do you fear?
- Determine how much of this risk you can bear, and
- Insure the remainder of the risk
Here’s a little more detail and some comments on these 3 steps.
Identify the risk
The trick here is to put the risk in dollars. In the case of life insurance, for instance, lay out the expected income that will be lost if the insured were to die. Rules of thumb are handy, but there is no substitute for laying out the cash flows.
Determine how much you can bear
This step is the one that is the source of most of the mistakes – you spend too much money if you take too little risk, and you can lose big if you take too much risk. The market will pay you to take risk. The premium you pay for an insurable risk has to cover not only the expected loss, but also the administrative expenses incurred by the insurance company.
Over the course of your life you will be taking many, many risks. So long as each of the risks is a manageable amount – i.e., no one event can “knock you out of the game” – you can expect the large number of risks to average very close to the expected loss. By accepting those risks, you will be keeping the money that would have been paid to cover the administrative costs of the insurance company.
The trick is to keep the level of each risk at that “manageable amount” – if you suffer a huge loss, it is very difficult to recover. The standard that we recommend is to accept risk up to the point where it would affect your lifestyle if events go against you.
This step provides an immediate application for most people: don’t buy “gadget insurance.” For most of us, our lifestyle will not be interrupted if the new electronic gadget suddenly stops working. So resist that sales pressure.
Speaking of sales pressure, you may find it useful to discuss these principles with your insurance agent. Many agents assume that their clients wish to have “everything covered” so they proceed to recommend coverage that entails almost no risk for the client.
Finally, let us add a word about some psychological aspects of this step. There is usually some comfort in being “fully insured.” Similarly, there is usually some pain in paying a loss even though it doesn’t affect your immediate lifestyle and you believe that your lifestyle will be better over the long term. For you, this combination of comfort and potential pain may be so great that you would prefer to bear no risk in these matters. That’s OK – just recognize that by avoiding risks that you could bear financially, you are incurring financial costs.
Insure the remainder
Buy an insurance policy, with a deductible amount that is the amount of risk you are willing to accept (from step 2).
Suppose I am thinking about collision insurance for my car. Here’s how I apply the 3 steps:
- Identify the risk – what do I fear? I fear that I will have an accident and incur costly damages to my vehicle.
- Determine how much of the risk I can bear. To replace my vehicle would cost a lot more than I am willing to bear. I could, however, absorb $500 of costs without too much pain. As noted above, I draw the line at the point where my lifestyle would be affected.
- I insure the remainder of the risk by purchasing collision insurance with a $500 deductible.
Some Comments on Life Insurance
There are several types of life insurance to choose from:
Term Insurance is pure insurance – it pays the beneficiaries if the insured dies, otherwise there is no payment of any kind. You can purchase term insurance with guaranteed renewal for a specified number of years, with either a fixed premium or with a premium that starts at a lower amount and increases as you age. Many carriers impose maximum age limits on purchases of term insurance.
Our View: The gurus like term life insurance and we agree.
Cash Value Insurance, also called Whole Life Insurance (and some other names as well) combines death insurance with savings. As with term insurance, the policy pays the beneficiaries if the insured person dies. In addition, some of the premium is invested to build a cash value over the life of the insurance policy. In order for the policy to build the cash value, the premiums are higher than the premiums for term insurance.
In the event that the insured does not die at an early age, this cash value is available to the insured as a lump sum or it may be converted into an annuity. The holder of a cash value policy may also borrow against the value that has accumulated. Unlike term insurance (which may have maximum age limits), cash value life insurance may continue in force to provide certain payment of funds upon the death of the insured. Proceeds from life insurance are exempt from income tax, so cash value insurance can be a useful part of estate planning.
Our View: The gurus generally recommend that you use term insurance to cover your life insurance needs and use other vehicles for your investments. We agree. Life insurance products often have significant fees, and the tax-deferment feature is inferior to 401k and Roth IRA plans (you put after-tax dollars into the life insurance policy and the earnings are taxed – at ordinary rates – when you withdraw the funds).
Credit Life Insurance is life insurance that is linked to a mortgage or other debt – in the event that the borrower dies, the insurance pays the balance of the debt. The premiums for the insurance packaged as part of the regular monthly payment, a convenient feature.
Our View: We don’t recommend credit life insurance for amortizing loans (loans where you pay down the principal amount each month.) In the early years of the loan when the outstanding balance is high, the probability of the borrower dying is actuarially relatively low. In contrast, when the borrower is older and the probability of dying has increased, the outstanding balance has been reduced. More generally, we recommend that you view your life insurance needs in total, and use term life insurance to cover those needs.
Managing Investment Risk
The 3-step framework for managing insurable risks (identify the risk, determine how much you can bear, and insure the remainder) isn’t especially useful for managing the risks in your investment portfolio. Higher returns go with higher levels of risk, and most of us simply must invest in risky assets to have realistic chances of reaching our financial goals. So the question becomes one of determining how much risk to take.
For determining the appropriate level of risk for you to take, we recommend a framework suggested by Larry Swedroe. The framework comprises a series of 3 gates, each of which must be satisfied in order to take the level of risk you are considering.
Gate 1. Are you in a position to take the risk? This question has two separate aspects. First, do you have a long enough time-horizon to reduce the risk to an acceptable level? (For stocks, we like at least 5 years and, even better, 10 years or more.) Second, is the combination of your job security and your holdings of liquid assets secure enough to permit taking the risk? If the answer to either question is negative, don’t take the risk.
Gate 2. Psychologically, are you willing to take the risk? Even if you are in a position to take a risk, don’t do it if it will give you stress and anxiety. Put differently, don’t take risk that pushes you beyond the “sleep well” level.
Gate 3. Do you need to take the risk? Even if you are in a position to take risk and are psychologically willing, don’t do it if you don’t need to. Don’t risk what you can’t afford to lose in order to try to gain what you don’t need.
We now turn to some aspects of risk management relating to stocks and bonds.
Managing the Risk of Stock Investments
You are probably already familiar with the concept of diversification to reduce risk. Life insurance companies rely upon this principle – they spread their risk by insuring many, many people. When you invest in the stock market, you can invest in a broad portfolio of stocks, or you can invest in a small number of individual stocks. Because it has diversification, the broad portfolio will have less risk (less variability in the returns) than will the investment in just a few stocks.
But won’t I get a higher expected return if I invest in just a few stocks? After all, I will have higher risk and that should give me a higher expected return. Interestingly (and quite useful as well), the answer is no.
The market will pay you to take risk. Indeed, one of the axioms of finance is that higher risk goes with higher expected returns. However, another theorem of finance states that the market will NOT pay you additional returns for taking additional risk that you could diversify away. (This result comes from the Capital Asset Pricing Model, known as the CAPM.) As a consequence, investing in just a few stocks exposes you to additional risk for which you will NOT receive additional compensation. This result is quite useful for risk management of your investments – diversify those investments where you wish to have less rather than more risk (such as the investments for your “don’t be poor in retirement” objective).
You can’t diversify away all of the risk in stocks – the market itself has large swings in returns (witness the past several years). So, even after completely diversifying your investment in stocks (investing in a total market index fund, for example), you may have more risk than you wish to bear. Now what?
You can extend the diversification application by diversifying across other asset classes. A common practice is to include bonds and some cash as well as stocks in your investment portfolio. Because bond returns, cash, and stock returns are not perfectly correlated, a mix of bonds, cash and stocks will have less risk than a portfolio entirely of stocks. There is, however, a disadvantage: bonds and (especially) cash have lower expected returns, so mixing them into the stock portfolio will reduce the expected return of the overall portfolio.<
As an alternative to using bonds or cash to reduce the risk of your stock portfolio, you could diversify by including real estate investments into the portfolio. The expected returns for real estate are more in line with the expected returns for stocks, so there will be less impact on the expected return of the total portfolio.
Holding Period. Another way to reduce the risk of stock investments is by using the time dimension. The variance in one-year returns for the stock market is huge: since 1926, one-year returns have ranged from negative 43% to positive 54%. But, looking at longer holding periods, we find that the variation in the average annual return declines. This decline is shown in the table below:
Common Stocks Range of Average Returns, 1926-2002
The implications are clear: a long holding period provides significant risk reduction for your stock portfolio. Note, however, that the risk isn’t eliminated. And, in the same vein, remember that very low probability does not mean impossible – even though we do not see a negative cumulative return from stocks from any 20 year period in the table does not mean that it cannot happen. On the more positive side, we greatly prefer a lower probability of adverse returns compared with a higher probability.
Managing the Risk in Bond Investments
Managing Default Risk
One way to minimize default risk in your bond portfolio is to invest in U.S. Treasury securities, which are considered risk-free from a default standpoint. Alternatively, you can invest in bonds with varying degrees of default risk, from AAA securities that are considered almost risk-free to “junk” bonds that carry significant risk of default. We would note, however, that the recent economic meltdown provided a strong reminder that “almost” risk-free is not the same as risk-free.
If you invest in bonds that carry default risk, it is important to diversify your holdings. The principles of diversification from the CAPM apply to bonds as well as to stocks: the market will not pay you to take risks that you could diversify away. Thus, if you invest in a small number of risky bonds, you will be taking additional risk without receiving any additional compensation.
Managing Interest Rate Risk
Bond values vary inversely with interest rates – bond values decline when rates rise, and bond values increase when interest rates fall. This is called interest-rate risk (the risk that interest rates will move, causing a change in bond value). Longer-maturity bonds are more sensitive to interest rate risk. For example, a 1 percentage point increase in interest rates (from 3% to 4%, for example) has no effect on the value of a bond that matures tomorrow. For a bond that matures in 30 years, however, this change in rates produces about a 12% decline in value. And yes, longer-maturity U.S. Treasury securities carry significant interest rate risk. Although U.S. Treasury securities are considered risk-free, that only applies to the risk of default, not the risk from changes in interest rates.
You can eliminate the risk of suffering a negative return on your bonds from interest rate risk by ensuring that you never have to sell a bond before it matures.
Thus, the broad rule for managing interest rate risk is to keep the maturity of your bonds in line with when you need the money.