Risk Management: The Key to Long-term Financial Success
- Tuesday, November 01, 2005
We hear this term all the time. But, what does it really mean? Risk, taken by itself means: danger; hazard; jeopardy. Management means running; administration; and supervision. Now, if you took those words separately and brought them together, you could say that risk management is running from danger. Of course, the "running" in this instance is actually referring to being in control, but given the current mood in the world, I thought literally running from danger (or hazard or jeopardy) was much more appropriate.
According to the IFCI Risk Institute (yes there is such a place. Is this a great country or what?), risk management is defined as: "The application of financial analysis and diverse financial instruments to the control and, typically, the reduction of selected types of risk." Huh? In layman’s terms, it means to not put all your eggs in one basket. Simply put, diversify.
As recently as the 1990’s, this philosophy was laughed at. Why diversify when all you have to do is throw a dart at a bunch of stocks and pick the one your dart hits? We have turned 180 degrees and the age-old use of diversification is once again chic. Warren Buffett, arguably the most successful investor in the world, was once asked about investing in a bull market. His answer: "A rising tide lifts all boats. It’s not until the tide goes out that you realize who’s swimming naked." Well, the tide has gone out, only unlike the tides, there’s not a predictable pattern.
Buffett has also said: "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well…. In the short run the market is a voting machine; in the long run, it’s a weighting machine."He understands the importance of investing with a long-term frame of mind. He has also said "for some reason, people take their cues from price action rather than from values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up."
These are difficult times, but you must remember the reason you originally began investing. It was to build wealth for the future. We knew there would be bumps and although these bumps have become more like big hills to climb, we must still keep our focus on the end.
Finally, we can’t forget about that other detriment to growing our wealth and that is inflation. I know what you’re thinking. "What’s that?" Inflation has not been an issue in our country for about 20 years, but it has never gone away. Inflation is an incredible wealth inhibitor. It inhibits wealth more than taxes. Think about it. If you earned 5% in your bank CD and inflation was 0% and taxes were 50% (extremely high), your wealth would have increased by 2.5% (50% of 5%). If you earned 5%, inflation was 3% (which is the average inflation rate over the past 75 years according to Ibbotson & Associates), and taxes were 0%, your wealth would have only increased by 2% (5% - 3%). Historically speaking, according to Ibbotson & Associates, we know that the historical returns of various investment vehicles are as follows:
Compound Annual Return (1926 – 2004)
Muni. Bonds 4.6%
Gov. Bonds 5.6%
Note: Past performance is not indicative of future results.
As you can see, in the past, stocks have provided the best defense against inflation. Does that mean you should have 100% of your money in stocks? Not at all, but it does mean that stocks should still be present in your portfolio.
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