Financial Risk Management and the Nervous Investor

October 20, 2008 by  
Filed under Financial Planning

Millions of panicked and nervous investors left the stock market in the last six weeks by selling what they held and/or by diverting their periodic investment contributions to cash or cash equivalents.  Ignoring for the moment whether such decisions made objective sense, that is the decision they made, based on their own tolerance for risk.  

Now these nervous investors are looking to rebuild their confidence to a point where they can re-enter the market.  For most Americans, that is what needs to be done for the long term, so that their retirement portfolios can withstand the ravages of inflation.  

There is no magic bullet for the fear of investing that was caused by the recent economic chaos.  No amount of cheerleading by our political leaders can transform doubt into confidence.  There is no single economic indicator that will tell us now is the time. 

What Should the Nervous Investor Do? 

Mr. ToughMoneyLove must admit to being one of those nervous investors.  I did not sell any of our long term holdings in response to the drop in the market indexes.  However, we do have a substantial cash position that I had intended on using to re-balance our portfolio next month.  Obviously, when you re-balance your portfolio in a market that has been down across the board, you end up spending the most on the investment allocation categories that have lost the most value, i.e. your biggest losers.  The question I have been asking myself is:  Do I have enough confidence to buy more of our biggest losers?  It’s a mentally painful question to think about right now.  For baby boomers like us, every investment decision takes on greater significance because the time available to recover from a poor decision is limited. 

My best estimate is that returns in the traditional equity and bond markets that most of us use for retirement investing will be flat to slightly positive for the next few years.  For some, this may mean that riskier investments are needed to compensate for these poor returns and put their retirement accounts back on track.  To compensate for this increased investment risk or to re-build investment confidence in general, it can help to consider other financial risk management strategies. 

Reducing Loss of Income Risk 

The risk of loss of job income is very real in this economy.  It is difficult to fully prepare and compensate for a job loss casued by economic conditions (e.g., layoff).  All I can suggest is save, save, save, including shedding discretionary expenses. 

For loss of income due to disability, this is no time to cancel your long term disability insurance.  If you don’t have it, you need to purchase it so that a disability does not cause you to raid your already impaired retirement accounts.   Mr. ToughMoneyLove does not consider this a discretionary expense.

Reducing Longevity Retirement Income Risk 

A retirement investment account that does not recover and/or does not grow in accordance with your existing retirement plan is not going to provide the retirement income that your plan may have estimated.  To evaluate and reduce the risk that your retirement income will be inadequate in amount or longevity, now is the time to revisit the Social Security component of your retirement income.  You can start by carefully studying your latest Social Security retirement benefit estimate that is mailed annually by the government.  If you do not have the latest data, you can use the online Social Security estimator

The financial risk management task that you want to focus on in reviewing your benefit estimate is understanding what your anticipated benefit will be and how much you can increase that benefit by waiting until age 70 to claim it.  For most baby boomers, you can add 8% in benefits for each year you delay claiming the benefit beyond your full retirement age.  Understanding and planning for that increased benefit may give you some feeling of comfort about your ability to compensate for the decreased income you may receive from your retirement portfolio. 

The longevity retirement income risk can also be reduced by using some of your retirement savings to purchase a single payment, immediate annuity.  Now is an excellent time for you to be studying annuity products.  This is a subject that requires a lot of investigation and evaluation and therefore is beyond the scope of this post.  Mr. ToughMoneyLove is now studying these products himself.  So far, I have discovered that annuity products are constantly evolving, with lots of options and cost variables.  I will be reporting on these products as I learn more about them.  In the meantime, you can learn more about immediate annuities here  and here.   You should also learn how to evaluate the financial strength of an insurance company that provides annuities because they are not guranteed by any government agency.

Reducing Shelter Expense Risk

Another financial risk management strategy that can build confidence is devising a plan to eliminate your most expensive permanent expense, your shelter expense.  If you own your home but have a mortgage, you can consider diverting investment funds to paying off that mortgage in the near term.  

If the numbers don’t work for you to accomplish that, then you should mentally and emotionally prepare yourself for a downsize, i.e., moving to a home and location that will allow you to have live without a mortgage.  If you have a plan for eliminating your shelter costs, you will be able to confidently assume more risk with your retirement investments.  To begin investigating options for reducing your shelter expenses by downsizing, take a tour of the cost of living data at bestplaces.net. 

A risk that is related to your shelter expense is the cost of long term health care.  I recently wrote a post about long term care insurance.  Purchasing that insurance should definitely be considered as a risk management move.

I have found that by systematically assessing and adjusting other financial risks that can affect my wife and me, and by taking actions to reduce those other risks, my feelings of discouragement from recent market events are diminished.  By doing a little risk management, we don’t have to sit on the sidelines and just accept the punishments that our government and the economy are handing out.  See if financial risk management works for you.


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One Response to “Financial Risk Management and the Nervous Investor”
  1. AreaVibes says:

    Very informative article Mr ToughLove. Unfortunately downsizing is something that many people will need to consider in order to minimize risk. If you are planning on taking the route of downsizing and need to consider a new city. Check out http://www.areavibes.com which provides detailed information about almost every city. This info includes cost of living, employment, housing, transportation and other important info that you might want to consider.

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