Wednesday, March 19, 2008

Reviewing Our Risk

"I have a million dollars in the stock market, because if I lose a million dollars, I don’t personally care." Suze Orman

Unlike Suze, I can't afford to lose a million dollars :-) Therefore, I like to give due consideration to my investments. Not only do I think about the potential gains, but I also think about the potential losses. This approach has theoretically kept me from scoring big wins (e.g. tech gains in the 90s), but, more often than not, it has probably kept me from experiencing big losses. The following three risks help me remember to consider potential losses:

  • Downside Risk. I feel it is good practice to consider the potential downside of any investment I make. For me 20% is a reasonable downside possibility. If a greater loss is possible, I try to avoid the investment. Of course, one never knows the true possibility until it happens. However, it's easy to check the historical results to learn what to avoid. I've had several stocks lose between 50 to 100%, permanently. These were typically stocks of turnaround companies or "unproven" companies with a potentially great idea. I've learned to avoid these types of investments. While I may miss a future 100 fold gain, I am likely avoid many more significant losses :-)

    In the short term, I think the downside risk of most stocks is very high and, therefore, am not making any new stock purchases.

  • Concentration Risk. It's been said that wealth is built through concentration and preserved through diversification. Concentration is how Warren Buffet, Bill Gates and Michael Dell amassed their wealth. However, concentration can be a two edged sword, leading to wealth destruction as was the case for Enron employees and, perhaps now, Bear Stearns employees, who were heavily invested in their company's stock.

    In my case, the company from which I retired also invested our retirement accounts primarily in company stock. While working there, I had limited diversification choices and chose to put some fund in a money market account. When I retired, 44% of our total savings were in company stock. My plan was to diversify the funds in the company retirement account by selling some stock through a covered call strategy. Unfortunately, the market drop in late 2007 and early 2008 caused the stock to fall below the call strike prices. At this time, my company stock is 45% of our total savings.

    This post is a good reminder that our original diversification plan didn't execute as planned over the last few months. Over the rest of 2008, I'd like to reduce the amount of company stock to 33% of our savings. While 33% is still high, it will be a good start.

  • Perfect Storm Risk. The current U.S. economic crisis is what I would call perfect storm risk. The combination of low interest rates and collateralized debt obligations led to a housing bubble which burst and caused the subprime mortgage and foreclosure crisis. That in turn has caused the failure or imminent demise of some mortgage companies, bond insurers and investment banks. Any one of the events by themselves would have been easily survivable. However, the combination of all these events have made the economic situation very challenging.

    My main concern at this point are the municipal bonds that I purchased in 2005. While these were all insured, Aaa bonds when purchased, the insurance companies and the municipality default risk is now higher due to the credit crisis. Fortunately, the bonds are only 4% of our investments began maturing at the end of 2007, with 85% maturing by 2010.

  • While I was comfortable with our investment situation six months ago, I am now more concerned with each of the risk areas due to the current economic situation. We have addressed the downside risk and the perfect storm risk by not making any new equity or bond investments. However, we will need to implement a new plan to reduce our allocation in company stock.

    For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

    This is not financial advice. Please consult a professional advisor.

    Copyright © 2008 Achievement Catalyst, LLC

    No comments: