December 15, 2009 in Investing

Taking financial risks without regrets

Living life without risks would be impossible, not to mention boring. The risk spectrum is wide, ranging from simply riding in a car to treacherous rock climbing or sky diving. Some forms of it, such as financial risk, threaten your pocketbook rather than life and limb.

Decisions like buying a home, starting a business and stock-market investing can result in big pay-offs — but they can have downsides as well. Luckily, with a little risk management, individuals can mitigate potential problems.

Buying a home

Due to recent events, a home purchase is viewed more suspiciously than in years past.

“I don’t think that people considered mortgages a risk in the past. It’s only in the past three years that we are looking at them as a risk,” says Jeri Lynn Fox, president of the Illinois Association of Mortgage Professionals.

But taking out a mortgage and buying a home does entail risk-taking. For one thing, it’s an expensive loan spread over many years, typically 30. A lot can happen in three decades, even if you don’t get caught up in lousy mortgage terms or owing more on a mortgage than your home is worth.

Consider the attendant costs of homeownership: property taxes, homeowners insurance and, for some, homeowners association dues, as well as the cost of maintenance and repairs.

“When something breaks, you don’t get to call the management anymore. You get to call the plumber when the toilet backs up, or you get to call the appliance repairman when the refrigerator conks out,” says Jim Smith, a CPA in Dallas.

Homeowners can lessen that risk by purchasing a warranty insurance policy.

“It’s like an extended service policy on your car that will pay for repairs. There is an insurance premium on that that you have to pay,” says Smith.

Another general risk involves buying too much house. It’s easy to mitigate that danger simply by scaling back your expectations.

“Whether we like it or not, a mortgage is an investment that, whether you have the money coming in, you have agreed to pay monthly. You may not be comfortable paying as much as the qualification ratios say you can pay,” says Fox.

For instance, lenders generally advise that your mortgage payment should not exceed 28 percent of your monthly gross income.

“Many families with two incomes like to qualify with just one person’s income because one person may be laid off,” she says.

Starting a business

Starting a business is a huge risk even as it is considered the best way to get seriously rich. But it is fraught with peril and uncertainty, and there’s no guarantee of financial security.

To insulate themselves from the downside, entrepreneurs should have a large reserve of cash to see them through the lean ramp-up period.

Darlene Butts, author of “Lessons From the Depression: Eliminating Debt the Old-fashioned Way,” struck out on her own as a financial adviser right before the stock market plummeted in 2008.

“We had taken the risk and thought that we had covered our bases. Nobody could have foreseen what happened in 2008 and the beginning of 2009,” she says.

Because she had planned for the worst-case scenario, she had enough money to cover her expenses for a year.

“We made sure we were financially prepared, and that certainly kept me in the ballgame and probably gave me the next opportunity because I had to make sure that I had the money to pay my expenses for a full year,” Butts says.

Even though her original business didn’t work out, she was able to write a book which she then self-published. This led her to find other authors who want her to publish their books.

“I think people give up too soon. As soon as things get really rough, they bail. To me, the biggest risk I could have taken would have been not taking that first leap and starting the business because I would have missed out on a career that I really love,” says Butts.

Investing

Nearly everyone will experience stock market risk at some point in their lives. It’s practically inescapable. With the decline of pensions and the necessity of saving up bushels of money for retirement, you need a substantial return. That means taking risks, including that of losing principal, to meet your goals.

For most consumers, investing in equities is necessary just to keep pace with inflation. Otherwise, their money loses its purchasing power over time.

“People are more concerned with the stock market going up 10 percent or down 10 percent, but they need to be more concerned with what is going to happen in five or 10 years with inflation,” says Dan Danford, principal and CEO at the Family Investment Center in St. Joseph, Mo.

Nevertheless, a loss of 10 percent or more can be unsettling. The best way to mitigate stock market risk is to make sure your money is diversified across a broad array of investments.

“The types of things you want to be diversified across are asset classes like real estate, commodities, fixed income and stocks. You also want to be diversified across size, like mid-cap, large and small; geography — international, emerging markets and domestic, and style — core, value and growth,” says Wade Slome, Certified Financial Planner and president of Sidoxia Capital Management in Newport Beach, Calif.

Though investing doesn’t have to be rocket science, it can be pretty intimidating for consumers who’d rather not have to learn anything about it. That’s where more risk enters the picture — if you end up following bad advice.

Many financial advisers or financial representatives at brokerage firms work on commission. So what is in the best interest of the client and what is most profitable for the adviser may be at cross purposes.

“There are a lot of sharks out there with many transaction costs and fees. There are fee-only advisers and I highly recommend people look into that because there are limitations on the conflicts of interest. Many operate under an RIA (registered investment adviser) and they have a fiduciary duty to make decisions that are in the best interests of their client,” says Slome.

Consumers routinely misjudge risk when evaluating financial decisions.

The best way to hedge your bets is to be diversified in all areas of your financial life, keep plenty of savings for emergencies and work with a competent and trusted financial professional.

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