Friday, August 22, 2008

how risky is my financial life?

According to Wikipedia - Risk is a concept that denotes a potential negative impact to some characteristic of value that may arise from a future event, or we can say that "Risks are events or conditions that may occur, and whose occurrence, if it does take place, has a harmful or negative effect". Exposure to the consequences of uncertainty constitutes a risk. In everyday usage, risk is often used synonymously with the probability of a known loss.

In Engineering the definition is put simply:

This begs the question for us all; How Risky is My Financial Life? Put more dramatically, To What Extent am I Risking Bankruptcy or Financial Hardship?

Factors that I am going to take into consideration to determine this are:
  • Allocation of Financial Assets
  • Employment Status and Stability
  • Alternative Income Status and Stability
  • Age
  • Health
  • Debt Level
  • Dependants
  • Time Horizon
  • Area and Country of Residence
  • Cost of Lifestyle
  • Definition of Risk
  • Flexibility of Lifestyle and Skillset
  • Current Net Worth and Income Potential
  • Untapped Resources
  • Others....

Readers are encouraged to provide comments and opinions on financial risk as I go through the process.

What defines Financial Risk? How Do I Guard Against Financial Risk? What Put Us In a Good or Bad Position? Generally, Whom Among Us Are Leading Risky Financial Lives?

1 comment:

pitz said...

I'd suggest that the highly leveraged are taking a huge amount of risk. I'd also suggest that the highly unleveraged are also taking an enormous amount of risk as well, although their risk will not necessarily translate into the loss of nominal dollars, but will probably, over time, barring heavy deflation, lead to a loss of real purchasing power.

I think a more useful exercise that financial planners should undertake is to value portfolios not on their so-called 'mark to market' valuations, but rather, to value them on the income and the sensitivity of that income to certain economic conditions.

For instance, a person might include a $1M house in their portfolio. If that house is in Vancouver, it probably provides a pre-tax imputed rent of $20k-$30k/year, with a reasonable amount of inflation indexxing in the rent.

Is that person with the $1M house 'wealthier' than someone who buys $500k of equity in a business with a P/E of 15, that provides a (tax-paid) income of $33,333, and is reasonably indexxed to inflation in the long run?

I'd suggest not. I'd suggest that the guy with the stocks is, in fact, wealthier, than the $1M Vancouver homeowner, even though the mark-to-market value of the stocks is 50% of that of the house, because the income from the stocks significantly exceeds that of the house.

IMHO, you can retire fairly safely on a portfolio that yields just as much in earnings, as you need after-tax income. The cost of replacing a $100k salary is, in my view, around $1M, assuming that the funds are non-registered, with the current market P/E of 15.