Reducing Risk to Protect Your Money
Tips and Techniques for Reducing Risk to Protect Your Money
Risk reduction is an important part of money management and running a business. Insurance companies do it every time they underwrite a new policy by estimating probable outcomes based on past behavior and other factors. So do restaurants and coffee shops when they hedge their costs on items such as coffee beans, wheat, and dairy products. Holding companies strive for it when they acquire enterprises for growth or diversification. How about you and your family?
The same techniques that are often used by some of the best corporations in the United States as well as around the world can do a lot of good for you whether you're a white-shoed banker on Park Avenue or a construction worker in the Rust Belt. It's unlikely you were ever taught to think this way in high school or even college, but it's time to start looking at your own life, assets, and earnings stream - both active income and passive income - as a business in order to protect yourself from the dangers lurking in everyday life.
Some of this material has been drawn from my older investing and risk management articles; updated to offer additional, useful information on the topic of risk reduction. Where vague, I've tried to expand on the concepts so I think even long-term readers of the site will find it helpful.
1. Keep Your Fixed Payments as Low as Possible Relative to Cash Flow to Reduce Your Liquidity Risk
I've made this statement before and I want you to think about it: It's not debt per se that puts someone into bankruptcy, it's their inability to make a payment. That's why I wrote Why Building Equity at the Sake of Liquidity Can Lead to Bankruptcy and A Lesson From September 11th - The Importance of Liquidity.
Put simply, you need a healthy amount of net working capital just as a corporate does. That is the money left over when you take all of your current assets and subtract out your current liabilities. In order to do that, you want to design a system that allows you to make fewer payments when your cash flow is low and higher payments when your cash flow is abundant. That's the reason fixed payments, such as those on a car loan or real estate lease can be so bad if the economy or market turns against you.
The people or institutions to whom or which you owe the money don't care that sales declined or you lost your job. They want repayment.
Anytime you think about adding an additional fixed payment liability to your balance sheet, think long and hard. To some degree, you're adding handcuffs to yourself and reducing your fiscal flexibility. There are exceptions to this rule of course - during periods of record low-interest rates, a shrewd person might acquire high-quality real estate investments selling at reasonable valuation rates relative to cash flow, that have the ability to raise rates quickly when and if inflation increases, financing the acquisition with a long-term, fixed-rate mortgage.
In this situation, locking in that interest rate for decades is a case of good risk management (though it would be even better risk management to buy the property outright and have no payment against it at all).
2. Use Your Cash to Purchase Income Producing Assets, Lowering Your Risk By Increasing Cash Flow
When you look at the data, the poor and the middle class tend to have a habit of buying things that decrease in value over time, as well as require upkeep and maintenance. (I heard one registered investment advisor quip that the average time a beneficiary takes to buy a new car after receiving an inheritance from a former client is about seven days.) Even worse, they overwhelmingly take out loans, then pay interest expense that is not tax-deductible, which is essentially the cost of "renting" money.
Whether it's the aforementioned new car off the lot, brand new furniture at retail price on some sort of special financing deal, watercraft, or expensive clothes, those destined for financial struggle prioritize these expenditures over funding new sources of annual passive income. They'd rather buy trinkets and baubles than dividends, interest, and rents. The self-made rich are the opposite. Toys come second, productive assets take priority.
In other words, the rich tend to invest money wisely by taking on debt to buy assets that generate, rather than consume, cash. They may borrow money to build or acquire car washes or storage units, not a car; to open a local McDonald's franchise or start a manufacturing business, not a flat-screen television. Not only should those assets increase in value if managed well, but the interest cost is actually tax-deductible, meaning it costs them less to borrow! A few years of this disparity, and the reason some people get richer and some get poorer becomes all too evident.
It's the power of compound interest turning small advantages into wide chasms over time.
Think about the same purchase - a notebook computer - one bought for a college student to go to work and another bought to handle accounting needs at a corporation. Our college student and accountant both buy the same system and it costs them $2,000. The student puts it on a credit card and ends up paying $500 in interest before wiping out the balance. Total cost: $2,500. After factoring in payroll and income taxes, he may need to earn around $3,400 pre-tax to afford it. If he gets an $8 per hour working off campus in a retail store, that will require 425 hours of labor, or a bit more than 21 part-time weeks.
The accountant, on the other hand, writes a check against the company line of credit. She, too, pays the same $500 in interest for a total cost of $2,500. However, the computer is depreciated down and the interest expense written off, reducing her tax bill by $750, making the net cost of the machine $1,750 ($2,500 - $750 = $1,750). It costs nearly 50% less for the same machine, with identical features, and an identical interest rate, due to the nature of the tax code. Not to mention that if the accountant grows his business, he will be generating far more profit and creating jobs, making him even richer.
This is why some businessmen and women are able to enjoy far nicer lifestyles during the growing phase of their business because they don't really appreciate just how much things would cost if they had to buy them personally. An older executive is a perfect illustration because the business may provide a lifestyle, such as showing up to a mahogany paneled office with a staff ready to bring you coffee whenever you want or traveling to France on the company jet, that would require a $20+ million net worth.
I've written about this countless times, but it's extremely important. You do not want to be dependent on one or even two sources of income for your lifestyle. When someone is laid off, they and their partner often don't cut expenses quickly enough because they think work will be easy to find (sometimes it is), leaving them to add to credit card balances or tap into much-needed retirement accounts. Just like General Electric, Berkshire Hathaway, or PepsiCo, you want multiple streams of income from different areas.
For instance, say you work in drywall for a local construction firm and your wife is a school teacher. That's two sources of income that aren't likely correlated (meaning if one gets laid off, statistically, the odds aren't that the other will be affected whereas if you both worked in the jewelry industry during a massive recession, that might be a higher probability). Now, imagine if you also owned an ice cream stand in town. You could save much of the labor by doing the work yourself and during summers, she could use her three-month vacation to work behind the counter, saving labor.
That's a third source of income that has nothing to do with your other two jobs. On top of that, you take all of your profit and buy into a low-cost dividend index fund that generates 3% to 4% in cash income each year, while the underlying stocks continue to grow over the long-term; that's a fourth source of cash.
When you keep your fixed expenses low, and use the tax code to your advantage by only borrowing (if necessary) for cash generating assets, a collection of diversified cash sources can help you build wealth much faster. That's all your trying to do to get rich - put more of your money to work - nothing more, nothing less. As one financial writer once said, it is that simple and that hard.
4. Maintain prudent levels of insurance coverage
Too much insurance can cost you millions in ultimate wealth because you'll end up making the insurance company rich instead of building your own portfolio. On the other hand, too little or no insurance can leave you devastated at the very time when you are much vulnerable. That's why a wise mix of life, health, disability, and some even argue retirement funding insurance can be an important part of your overall planning strategy.
On this topic, you'll need to delve into a more specialized source. About.com has a tremendous amount of information on insurance both for individuals and businesses so I encourage you to browse the network for information by some of our other guides.
5. Don't tap your retirement accounts for any reason short of health problems
This isn't always true, but for the most part, it's a horrible mistake to tap into your retirement accounts to pay bills because in the event you need to declare bankruptcy, courts will often allow you to keep a major portion of what you've put aside for your golden years. Not to mention that any withdrawals would likely be taxed heavily and incur penalties from the IRS.
That's part of what worries me about the most recent credit crisis. People might very well be tempted to cash out of their 401k or IRA accounts to keep up the payments on their primary residence. If they can't get themselves out of the mess, or they are hit with a run of bad luck such as losing a job, they have now decreased their net worth substantially, transferred a bit portion of their wealth to the Federal Government, and are still left wiped out with nothing, or very little, to their name.
Had they managed the crisis with more knowledge, they might have been able to salvage a big part of their assets even if they did lose their house. That would make it far, far easier to start over and that's what you should be concerned about if you ever reach that point. As many of you will no doubt remember the words of the immortal King Koopa (Bowser), the enemy of Mario over 25 years ago when he debuted in the United States and later had his own television show: "He who lives to run away lives to fight another day." That same advice would serve many people facing disaster well.