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Why most “experts” won’t tell you the truth about risk? January 30, 2009

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Most people are afraid of financial risk; even the word risk scares the majority.  Look at the commercials for investment firms and financial planners; they don’t even mention the word, just tell you how strong they are (we know that is a lie), or how they are there to protect your assets (another lie).  If these folks were being truthful, they would tell you the following:

There is no such thing as a risk-free investment.  Your rate of return will depend upon your willingness to accept risk.  The real issue is not whether you want to take risks,  but which risks you want to take.

If there is one financial truth you learn from my blog, please learn the above statement. 

In my opinion the greatest risk taken is by people who arrange their lives around avoiding risk.  These people are fooling themselves into thinking they can avoid the risk of life. 

Once you accept the fact of risk as unavoidable you can then plan and manage risk.  Honesty with yourself is the starting place.  Look at your savings, your retirement accounts, your assets.  If you really take a look can you honestly say they are enough to take care of you during your 20 years in retirement?  Or, are you thinking, as soon as the kids are grown up or when we get this house paid for or there isn’t enough money to pay my bills now how am I going to save or any other excuse?  Because there is always something even after you get through all those events.  I had some clients, nice people, who have $125K in their 401K.  Used to be around $200K.  They are in their late 40s.  A couple of kids.  They have 90K in income.  I asked them, how much they need to retire on?  No idea.  So I ask them if they think their plan will get them there?  No answer.  So, I suggest building a plan starting with their current reality.  They would think about it!  Think about it??????  What is there to think about?  I here from someone else they put their 401K from a stock to bond mutual fund.  Ouch, with interest rates so low as soon as interest rates rise their bond fund will drop.  They don’t know this. They don’t understand risk.

Now here is another one of those truths about money.  You can manage risk without severely curtailing your return.

The common advice about risk is as follows:

Keep your money in a bank because it is protected from loss by the FDIC; or

Diversify your stocks [usually by owning mutual funds]; or

Pay off all your debt including your mortgage; or

Perform asset allocation [usually on your mutual funds]; or

Buy insurance products because of the guarantee against loss; or

Investing in [stocks, real estate, options, commodities] is too risky; or

Get a good career and you will never have to worry about money.

All of these statements do one thing.  Allow you to pretend that risk isn’t there.

It is.  Accept the fact of risk and learn to manage it in ways that doesn’t drive your rate of return down to a point of having no chance of reaching your financial goals.

Let’s talk about overall strategy! December 8, 2008

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There are two things that I agree on with the traditional financial planning community.

1. You should have reserves to help you through the tough times, because there will be tough times; and

2. Whatever strategy you choose (or allow someone else to choose for you), there is no reason to allow your fear/nervousness to get the best of you and change or eliminate that strategy based on fear.

Now, here is the Shafer Financial Way:

1. Create reserves first.  Save money inside a liquid fixed rate investment like a mutual fund until you have 6 months worth of expenses.  But this is a short term strategy to get started with.  Develop a long term strategy.  Perhaps start funding an Equity Indexed Universal Life Insurance policy, or use the money market account as both a reserve account and a pool in which to periodically buy Berkshire Hathaway stock.  In short, long term create reserve accounts that also will hedge against inflation for you;

2. Build a wealth creation plan.  This plan must be specific to where you are currently, where you want to be, and when you want to be there.  For example. your current working net worth is $40,000 and you want to have a working net worth of $3m in 25 years.  Then you need to create the investment(s), which will give you the best chance of getting to your goal with the least amount of inherent risk.  For example, if you need to get a 15% rate of return to reach your goal, then you need to build inside the plan the right investments that can accomplish that for you, using historical rate of return data as your guide.  You simply can’t build a reasonable plan based on beating the market, or based on financial instruments that have historically underperformed your needed rate of return;

3.  You need to fully understand the risk of failure to reach your financial goals; 

4.  You need to put all your resources to work for you.  If you have over 50% of home equity in your home, and you can take out equity to get you to the 80% mark, do it and put those dollars to work for yourself.  Don’t waste precious cash flow on luxury items until you can do so and still remain on goal.  That means buy cars that are over two years old, and don’t buy gas guzzlers.  Put off buying that entertainment center/50 inch flat screen, etc. until you can do so without having to put it on your credit card (unless it is only for payment convenience).  Concentrate on how you can increase your cash flow by starting a business, changing your job, etc.;

5. Make sure you take into consideration taxation.  It is most peoples #1 expense;

6. Don’t be afraid to take reasonable risks in order to invest in projects you are sure about, change your life to a wealth building life, and create the life you want to live.  It won’t happen if you don’t assume some risk;

7.  Find a mentor who has made his/her wealth or preferably pay for a wealth coach.  A wealth coach can make you hundreds of thousands of dollars (or millions if you have enough time) by just keeping your eyes on your goals.  Yes, this is self serving, but it is also true.  Think that Warren Buffett, Tiger Woods, Michael Phelps, etc. didn’t have coaches/mentors?   Of course they did.  Financial services sales people are not necessarily wealth coaches (usually they aren’t).  Wealth coaches might also offer financial products for sale, but they must not mix the two roles at the same time.  Look for a wealth coach that will refer you out to purchase financial products, therefore maintaining the integrity of the wealth coaching role ;and

8.  Now is the time to start.  Build your plan before the end of the year.  Implement it as soon as you can.  Change your life for the better! 





Risk; Final Words October 4, 2008

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In the investment world, like life in general, you can never avoid risk.  Instead of trying to avoid the unavoidable the point is to embrace and manage risk.  The best way to do that is to build a plan and stick to the plan until something fundamentally changes.  Its funny, people have made money trading in stocks, have made money by buying and holding stocks, and by investing in fixed income securities, investing in real estate, but they all say the same thing; I constructed a plan and stuck to it!

What that should tell us is that you need to build a plan that has staying power.  If you are investing in real estate and have to flip a property in a short period of time because of negative cash flow, then you are asking for problems.  If you are investing in stocks and emotionally not prepared for down trends, haven’t plan for them, then you are again asking for problems.  There are ways to invest in stocks that doesn’t depend on stocks going up all the time and there are ways to invest in real estate that doesn’t depend on large amounts of capital appreciation.  That is what I am talking about when I say manage risk and embrace it.

The bottom line is active investors have a plan for all market situations, while passive investors don’t.  Active investors have a plan built on historic evidence, while passive investors don’tActive investors have accounted for all contingencies while passive investors haven’t thought about them. 

At the Shafer Wealth Academy (www.shaferwealthacademy.com)  we think about what history tells us will happen and we plan for it.  You don’t fear what you already are prepared for!

Risk III: Emotional Risk October 1, 2008

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I have had several “financial planners” who have told me in discussion that they don’t suggest certain strategies because their clients wouldn’t be able to sleep at night.  Although I don’t agree with the logic, there are certainly people who forego activities because of the “good night sleep” factor.

Emotional risk is pursuing strategies that so unsettle one as to keep them from behaving rationally. For example, every time the stock market goes down significantly, many people sell their mutual funds/stocks because they fear more loss. Other people fear debt so much as to pay down their mortgages or put large down payments on their houses feeling like there is less risk in this strategy. Or others never consider strategies or self-employment because of an emotional attachment to a weekly paycheck or consistent earned interest.

I argue that emotions can be overcome with rational planning. If you have a specific plan, employ it consistently, and track its progress then one can overcome the negative emotions, fear, with a positive emotion, comfort. But here is the sticky part. If your plan is only to overcome a negative emotion, like getting rid of debt or risk, then you will never get to that comfort part because as soon as you succeed, you will have another fear supplant the current fear and start the cycle over again.

For example, if you eliminated the risk of equities from your life, and had your money in a bank CD or savings account, the current bank failure scare would ratchet up your fear again and cause you to pull your money from banks.  Or if you were using your home as a savings account, paying down your mortgage, the current real estate market would again ratchet up your fear and probably cause you to lose sleep or even worse cause you to sell your home in a poor market.

The alternative is to build a plan that history has proven to work.  Put your emotional energy into the implementation of the plan, and allow for the long term financial winds to push you past the finish line!


Of course having a wealth coach to help build your financial plan and walk you through the implementation process might help too. 🙂

www.shaferwealthacademy.com for your wealth plan!

Risk; Let’s talk about risk a misunderstood concept September 29, 2008

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This week is risk week at Uncommon Financial Wisdom.  I will post all week on risk, what it is, what it isn’t, how to manage it.  But first let’s talk about what risk is!

I divide investment risk into four areas, strategic risk, systemic risk, emotional risk, and longevity risk.  Today we will talk about strategic risk.

Strategic risk is a variable that often gets left out of the discussion. It is the risk that your strategy will not give you the needed returns to reach your goal.

It easiest to understand by using specific examples. Let us begin by saying you have built a wealth plan that requires you to get a 10% rate of return from your investments in order to reach your goals. Now you look at the world of investments and you note that the stock market has returned 10% since WWII, real estate has returned 6%, and bonds 6%. So you figure equities is where you want to be.  However, what are the chances you can get this rate of return?  That is the risk.  Since, you can’t buy the whole stock market you settle for a broad based indexed mutual fund.  However, all mutual funds have expenses.  Now we know that the average mutual fund has returned around 7.5% over the last 35 years. Not bad, but we can’t find a single mutual fund that has returned that high over that long of time period, and certainly we can’t find one that has returned 10%.  So that forces us to trade mutual funds searching for funds that are doing well while our existing one is not in order to try to pump up the return.  But research has shown that active trading, on average, lowers our rate of return.  So for this investment we see there is a large amount of strategic risk.

Lets look at real estate. On the face of it a 6% return will not get us anywhere close to our 10% requirement. But, we can safely use leverage with real estate. Lets say we purchase our re investment with a 80% Loan to Value mortgage, so we are leveraged 4 to 1. Now there are huge swaths of the country where putting 20% down will give you a positive cash flow, but lets be conservative and say our expenses equal our costs for this real estate.  For the time being lets not count our depreciation, real estate taxes, and mortgage interest, tax savings.  And lets say we allow our loan to value to go to 50% before we put that equity to use again so we have a two to one average leverage over the long run.  With a two to one leverage situation for every 1% appreciation we get 3% rate of return.  So if over the long run we get the historic average (6%) our rate of return will actually be 18%; well more than we need to reach our goal.  Now what is the strategic risk with real estate? If the long term real estate return is only 4% (33% less than the historic average) we still make our goal with some to spare.  Would we say that our strategic risk is exponentially less than with mutual funds? I would!  Comparing odds, what are you chances of getting 25% more than the historic average for mutual funds compared with getting 33% less than the historic average with real estate? And remember we set aside the tax advantages for real estate, and did not count any positive cash flow that would likely accumulate!

Here is another quick example. The historic average over the last 40 years of an average mutual fund (can’t really find a mutual fund that has been around that long with the same money manager) is 7.5%.  The historic average for Berkshire Hathaway over that same time period is 21%.  What are the odds of that Berkshire Hathaway going forward produces returns 1/3 as high as its 43 year history?

Note that financial planners never talk about the strategic risk of any given investment. Nor do they build plans that give you any idea of what the needed rate of return will be to obtain goals. Now you know why.


Let’s me teach you how to build the bridge to your goals instead of that bridge to nowhere!

To regulate or not, that is the question! September 23, 2008

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Many commentators including myself trace the genesis of the current financial trouble to the repeal of the Glass Steagall Act and the passing in 1999 of the Gramm-Leach-Bliley Act.  A quick background.  The Glass Steagall Act of 1933 was passed as a result of commercial bank failures when they took on too much risk causing them to fail (sound familiar?) and take with them their deposits.  It kept commercial banks from investing in high risk activities that investment banks take part in.  Part of the ACT was the forming of FDIC government backing for deposits in exchange for not being able to get involved in high risk activities that had led to massive bank failures.  The thought was that the deposits of average folks would be protected, giving commercial banks an advantage in obtaining funds which could be redeployed in conservative ways as a foundation for the economy.  During the 1990’s through much lobbying the investment banks, insurance companies and commercial banks were able to convince the government to repeal this, signed into law by Clinton in 1999 after a bipartisan vote in congress that was veto proof.

Now in 1999 there was a full on economic change happening to Wall Street as investors were demanding high returns for their capital and were not reticent to move their money if they were disappointed.  Hence the investment banks taking on more leverage and trading in mortgage backed securities backed by sub-prime loans.  Now, commercial banks seeing the amount of money being paid for these MBS’s and having pressure to increase the return they give to investors startedto be tempted.  Some started to originate mortgages with questionable underwriting because they could sell these out and make huge profits.  Other banks and mortgage companies were formed just to originate sub-prime mortgages.  Still other small regional banks were able to grow exponentially by originating questionable loans. Insurance companies  (AIG) started to get in the business too by either trading in these MBS or insuring them.  In short, since there was no longer any fire wall between commercial banks, insurance companies and the more risky investments and there was intense pressure to increase returns to investors many companies felt compelled to take on the added risk in order to stay competitive to investors eyes.

As this easy credit pushed real estate pricing up well past what average people could afford you had a classic bubble that when popped, started a chain reaction that has taken down investment banks, commercial banks and 1 insurance company.

Readers who have a different understanding of this are encouraged to reply to this post.  This is only my thinking on the subject and I hope others can add or disagree with these ideas.  Somewhere in this is a very important point about regulation!

Additionally, I have read a really good book called “Supercapitalism” by economist Robert Reich.  It really puts together much of the economic history into a easily understood framework.  I think readers will be surprised by some of the suggestions coming from this former member of Clinton’s cabinet!

On Hedge Funds and Criminality June 20, 2008

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Prosecuters have arrested a couple of Bear Stearns hedge fund managers for lying to folks about how well their hedge fund was doing. :-).  Give me a break.  First, they are using e-mails as the basis of the indictment.  That’s just lazy lawyering.  If that is all they have this lawsuit will fall apart soon.  But the greater question is who was victimized and why this “lying” is any different than the other Wall Street “lying.”

People who purchase hedge fund shares have to be well heeled.  Over $1M in net worth and over $200,000 in annual income is required to become an accredited investor to invest in hedge funds.  Then there is the prospectus, which lays out in bold that hedge funds are a risky investment that might “lose their entire value.”   So given that these folks, are by definition, people who can afford the risk, and are told up front that they can lose the entire investment, I have a hard  time finding a victim.  Greed clouded their judgment, or at least caused them to take on much risk, for which they learned why they call it risk!

Now, as to the lying aspect.  It was their job to convince folks to buy into the investment just as it is the job of the Wall Street army to convince folks to invest their money in stocks, bonds and mutual funds.  Just because their are some e-mails that congratulate themselves over doing what they are getting paid to do does not mean they are criminals?  How does what they did differ from what the average mutual fund salesmen do?  They sale the sizzle, slyly promising oversized returns, when the reality is for everyone to see.  Sometimes hedge funds deliver great returns, more often they don’t.  They don’t advertise hedge funds as low risk activities to the middle class, so where is the crime?  If you argue that the hedge fund managers should have devalued their assets earlier, you are probably right, but no one could have predicted the total meltdown of the sub-prime mortgages that would occur.  Hope spings eternal even with Wall Street veterans.  That to me is normal human behavior, not criminal activity. 

The truth is that in investing, getting greedy, is a sure way to get burned.  Don’t act like a pirate looking for the buried treasure.  Having a purposeful plan, based in conservative assumptions, is the way to get to your goal!