Risk Management for 2020
Warren Buffett says of risk, “Risk is not knowing what you are doing.” Again, the keyword here is “you,” not the investment.
Over the years, I’ve come to define RISK as:
My friend and stockbroker, Tom Weissenborn, offers these two rules when it comes to investing in stocks:
- If you don’t understand how the company makes money, don’t invest in it.
- If it looks too good to be true, then it probably is. Just like my own folly once upon a time, Karen learned this particular lesson the hard way.
As you’ve learned, in the world of investing, there are no investments that are 100% guaranteed to be safe (free from losses), but there are things you can do to reduce investment risk and increase your chances of success:
- Give yourself a financial education.
- Gain hands-on experience by actively investing (a small amount of) your money.
- Understand the investment and the return on the investment.
- Have control over your investments.
- Become your own financial advisor.
Many people think that higher returns on investment require higher degrees of risk. That is not true. To me, having a well-diversified mutual fund portfolio and savings in the bank is a lot riskier than what I do. It is all a matter of financial intelligence.
When asked if I thought it was risky to be investing in crashing markets, I replied, “There is always a risk.” I then completed my thoughts by saying, “The ups and downs of markets do not affect why I invest or what I invest in.”
Instead of taking on a new challenge and learning, they play it safe. Now, this doesn’t mean you should do stupid and risky things. There are many things we could do but choose not to. For example, I could have chosen to climb Mount Everest. Or I could have signed up for NASA’s astronaut program. Or I could have entered politics and run for public office. My point is that I chose my next challenge carefully, not haphazardly. I asked myself, “What will my life be like if I take on this challenge and succeed?” It’s the same question I ask you to ask yourself.
Improve Your Financial Information
There is a bit of wisdom that goes, “You need to learn to walk before you can run.” This is true with financial intelligence. Before people can learn how to earn exceptionally high returns on their money, they need to learn to walk; that is, to learn the basics and the fundamentals of financial intelligence.
One of the reasons so many people struggle with leveraging money is because they are taught to turn their money over to financial “experts,” such as their banker and their mutual fund manager. The problem with turning your money over to financial experts is that you fail to learn, fail to increase your financial intelligence, and fail to become your own financial expert. If someone else manages your money and solves your financial problems, you can’t increase your financial intelligence. Actually, you are rewarding other people for theirs instead—with your money!
It’s easy to increase your financial intelligence if you have a strong foundation of financial information. But if your financial IQ is weak, then new financial information can be confusing and have seemingly little value. One of the benefits of being dedicated to your financial education is that over time you will be better able to grasp more sophisticated financial information just as mathematicians are able to do complex equations after years of practicing math problems. But, again, you need to learn to walk before you can run.
Protect Your Money
A simple truth is that the world is out to take your money. But not all who take your money are crooks or outlaws. One of the biggest financial predators of our money is taxes. Governments take our money legally. If you physically work for money, you will pay taxes. The harder you work, the more you make, and the more you pay in taxes. As you may or may not know, the U.S. tax system is a sliding scale that charges a higher percentage of your money in taxes for the more you make. Under this system, people who work hard, get promoted and make more money are actually punished for their initiative.
If a person has a low financial IQ, he or she will pay more in taxes. An example of financial IQ is someone who pays 20 percent in taxes versus someone who pays 35 percent in taxes. The person who pays less in taxes has a measurably higher financial IQ and thus, lower risk.
Budget Your Money
Budgeting your money requires a lot of financial intelligence. Many people budget money like a poor person rather than like a rich person. Many people earn a lot of money but fail to keep a lot of money, simply because they budget poorly. For example, a person who earns and spends $70,000 a year has a lower financial IQ than a person who earns $30,000 and is able to live well on $25,000 and invest $5,000. Being able to live well and still invest no matter how much you make requires a high level of financial intelligence. Having a surplus is something you have to actively budget for.
Leverage Your Money
After a person budgets a surplus, the next financial challenge is to leverage their surplus of money. Most people save their financial surplus in a bank. This was a smart idea before 1971—before the U.S. dollar became a currency. Also, after 1974, workers needed to save for their own retirement. Millions of workers did not know what to invest in, so they invested their financial surplus in a well-diversified portfolio of mutual funds, hoping this would leverage their money.
A person who puts money in the bank, for example, has no leverage. It’s the person’s money. A dollar in savings has a leverage factor of 1:1. The saver puts up all the money. For my investment in the 300-unit apartment house, my banker put up 80 percent of the $17 million real estate investment. By using my banker’s money, my leverage is 1:4. For every dollar I invest in the deal, the bank lends me four dollars.
Many financial advisors will tell you that higher returns mean higher risk. In other words, leverage is risky. That is absolutely false. Leverage is risky only when people invest in assets that they have no control over. If a person has control, leverage can be applied with very little risk. The reason most financial advisors say that higher returns mean the higher risk is simply because they sell only investments that allow very little control.
While savings and a diversified mutual fund portfolio are a form of leverage, there are better ways to leverage your money. You can train a monkey to save money and invest in mutual funds. That is why the returns on those investment vehicles are historically low.
Editor, Rich Dad Poor Dad Daily