By Dr. Jim Dahle, WCI FounderThere are a lot of financial risks in your life. I frequently run into people who are worried about the wrong ones, though. They seem to have little insight into what their biggest risks are. Our biggest financial risk frequently changes as we move throughout life, and it is important to recognize and protect yourself against your biggest risks. Here are some of the financial risks that you might run into at some point during your life:
- Market risk
- Interest rate risk
- Inflation risk
- Risk of running out of money due to inadequate returns
- Risk of disability
- Risk of death
- Leverage risk
- Small business/entrepreneur risk
Now, let’s go through a few scenarios. We’ll first list the financial risks that each person is running, and then identify the largest risks and how to protect against them.
Scenario #1: A Recent Retiree
Jill recently became financially independent, and she retired. She is 68 years old and single, and she has her home paid off. She has a $1.5 million portfolio invested entirely in stocks with a sizeable small value tilt, receives $25,000 per year from Social Security, and spends $85,000 per year. Which of these financial risks is she running?
- Market risk
Interest rate riskInflation riskRisk of running out of money due to inadequate returnsRisk of disabilityRisk of deathLeverage riskSmall business/entrepreneur risk
Market Risk
In this carefully crafted scenario, she is quite protected from most of these risks. Given her aggressive portfolio, her returns are likely to be adequate to keep up with inflation and provide enough of a return to support a 4% withdrawal rate. She faces serious market risk, however. In a bear market, she could lose 50% or more of her portfolio. That would introduce sequence of returns risk, and it could possibly even cause her to panic and sell low, a real tragedy.
Protection Measures
She could protect herself from this risk by dialing back the portfolio risk a bit. She could have a less severe factor tilt, add some bonds or cash to the portfolio, and maybe even diversify a bit into real estate to protect against an isolated stock downturn and improve income. Yes, this will somewhat increase her inflation risk and risk of running out of money, but a more balanced approach between her risks is likely indicated.
More information here:
Scenario #2: The Scaredy Cat Retirees
Jose and Isabella also recently retired. They are 63 years old and are already collecting both of their Social Security checks for a total of $35,000 per year. They have no debt. They spend $90,000 per year and have a $1 million portfolio invested in a combination of nominal bond funds and CDs. Which financial risks are they running?
Market riskInterest rate risk- Inflation risk
- Risk of running out of money due to inadequate returns
Risk of disabilityRisk of deathLeverage riskSmall business/entrepreneur risk
Inflation Risk/Running Out of Money
This couple has serious exposure to inflation risk. Just a few years of double-digit inflation would seriously erode their asset base. Their only protection against inflation is the Social Security adjustment they would see each year. Perhaps more significantly, they have a portfolio with a nominal yield of something like 2%-3%, but they are withdrawing $90,000-$35,000 = $65,000/$1 million = 6.5% per year. Even if inflation were 0%, which it almost surely will not be, they will drain their entire portfolio at some point in their 80s and be living on just Social Security.
Protection Measures
The most reliable protection is to simply spend less money. This will dramatically reduce the risk of running out of it. In addition, if they were to run even a little bit of market risk (perhaps increasing the portion of the portfolio dedicated to risky assets, such as stocks and real estate, to 25%-50%), they would further reduce that risk and protect themselves against inflation. Here are some other potential measures:
- Swapping out some of the nominal bonds/CDs for TIPS would also provide some inflation protection. There are other alternatives, too.
- They could purchase a Single Premium Immediate Annuity (SPIA) to protect against running out of money, although it wouldn’t do much for inflation risk.
- They could use some of their home equity to support their lifestyle. They could do this most simply (but not necessarily most easily) by downsizing and investing the recaptured home equity.
- They could also run some leverage risk by taking out a mortgage or HELOC and investing the freed-up assets in hopes of earning a higher rate than the mortgage.
- A reverse mortgage may also be an option, although it comes with serious downsides and additional risks (at least to any potential heirs!).
Scenario #3: The Young Dentist
Lavar is a young dentist, fresh out of school, with three kids and a stay-at-home wife. He has a $500,000 student loan burden (refinanced to a variable 5.4% on a 15-year term), a $500,000 mortgage (fixed at 4.5%), and a $500,000 practice loan (variable 10-year loan at 5%). He made $150,000 last year and hopes to break $200,000 this year. He has not purchased any disability or life insurance because they are struggling to support their lifestyle while covering all of the debt payments. There is no portfolio yet either, but his employees are bugging him about putting in a retirement plan at the practice. What financial risks is he running?
Market risk- Interest rate risk
Inflation riskRisk of running out of money due to inadequate returns- Risk of disability
- Risk of death
- Leverage risk
- Small business/entrepreneur risk
Risk of Disability
Lavar is running a ton of risk in his life. The biggest risks for him and his family, however, are his death and disability. His ability to earn a living is his greatest asset, and it is completely unprotected. Luckily, if he is healthy, this problem is easily solved with some simple disability and life insurance. Yes, that is going to cost him some money, but frankly, he can’t afford not to have this insurance at this time in his life. Even if it means putting off investing or a debt payoff, these insurances are absolutely critical for him and his family.
Leverage Risk
He is also running a pretty massive leverage risk. He owes 10X his income. To make matters worse, 2/3 of this debt is exposed to interest rate risk. While I am often an advocate of running interest rate risk yourself when you can afford to do so (i.e., refinancing student loans to a five-year variable rate when you’re planning to pay them off in two or three years), it does not appear that Lavar can afford to do so. In addition to all of this, Lavar is struggling to get this practice going. He lies awake at night wondering if he is going to make payroll each month. He has serious small business risk as well.
Protection Measures
Perhaps the best solution for Lavar and his family at this time is to get very hardcore about personal finance. He needs to boost income, cut spending, and get himself some breathing room. Any spending he does should be business spending directly aimed at increasing income through marketing or developing new skills, products, and services. Perhaps salaries at the practice can be cut in the short term by changing contracts to increase profit-sharing or even equity in hopes of improving cash flow now.
The debts can be restructured (and made fixed or even longer-term), but if he can double or triple his income, they all become much more manageable. If his practice is nowhere near full, perhaps he can even do some moonlighting as an associate for a while to increase income.
More information here:
How to Think About Risk and Why It’s So Hard to Quantify
Risk vs. Reward — How to Find the Balance
Scenario #4: The Physician Real Estate Guy
Patrick is a single hospital employee nephrologist ($240,000 income), a few years out of residency who really got into real estate investing recently. He has no disability insurance. He has refinanced his $250,000 in student loans to 3.5% fixed, but he doesn’t want to pay them off any faster than he must so he can invest more. He has about $50,000 in a 401(k). He recently moved into a duplex he bought, and he is renting out the other side. In the last year, he has closed on two other properties. One of these properties he used to live in and bought with a physician mortgage with 5% down. The mortgage is less than the rent, but for some reason, something seems to come up every month. Therefore, he is cash flow negative on the property. The other property is a fixer-upper that he hopes to get a renter into soon. What financial risks is Patrick running?
- Market risk
Interest rate riskInflation riskRisk of running out of money due to inadequate returns- Risk of disability
Risk of death- Leverage risk
Small business/entrepreneur risk
Patrick has three main financial risks to be concerned about.
Market Risk
He has some market risk as the real estate market could turn on him. Property values could plummet, and rents could even drop. Maybe he can’t find a good tenant for the fixer-upper. He worries a lot about that risk, but in reality, his other two risks are far larger.
Risk of Disability
He should get disability insurance ASAP, as his ability to work clinically is still his greatest asset and is holding the whole house of cards together.
Leverage Risk
He is also massively overleveraged. He owes hundreds of thousands of dollars. He doesn’t have a single cash-flow positive property helping him pay the bills. Getting on top of his cash flow situation and debt-to-income ratio needs to be a big priority.
Protection Measures
When you find yourself in a big hole, Step 1 is to stop digging. He needs to stop buying properties with money he doesn’t have to impress people he doesn’t even like. He needs to take a deep breath and slow down this real estate train. It isn’t that real estate is a bad investment. It isn’t even that these are bad properties. But the method and timing of his purchases are putting his whole financial life at risk. When real estate investors go broke, it is usually like this. Add a couple more cash flow negative properties into the mix or have even a minor hiccup in the real estate markets, and it all collapses.
Perhaps one solution is to get this fixer-upper done and flip it. Maybe he makes some money, but if nothing else, he reduces his debt-to-income ratio. He might also want to sell his old home if he isn’t too far underwater on it. He simply needs a stronger base with which to build his empire. Putting 25%-35% down on these properties likely turns them into assets putting money into his pockets every month instead of liabilities that are taking money out.
A minor point, but his real-estate-to-stock ratio is awfully high, and he may be missing out on a lot of the tax benefits of using retirement accounts, too. Perhaps starting a Backdoor Roth IRA and investing it into index funds each year in addition to maxing out the 401(k) could help balance that. Getting those student loans out of the way would also improve his cash flow.
Scenario #5: The Multi-Millionaire Entrepreneur
Wanda has done very well for herself. She has never been a fan of debt, so she paid off her student loans quickly after school and bought appropriate amounts of life and disability insurance. She even paid off her house in just seven years. She has ramped up the spending quite a bit, but she still saves about 20% of her gross income per year and has a million dollars spread across a portfolio of stock and bond index funds—both inside and outside retirement accounts. She also has a couple hundred thousand dollars in real estate syndications that have done pretty well.
She started a side business a few years ago, and it really took off. She cut back on her clinical work, and her husband has quit his job and is now staying home with their two kids and helping out in the business where he can. She recently got a $3 million buy-out offer for the side business, and she is having trouble deciding what to do. What financial risks is she running?
- Market risk
Interest rate risk- Inflation risk
Risk of running out of money due to inadequate returnsRisk of disabilityRisk of deathLeverage risk- Small business/entrepreneur risk
Entrepreneurial Risk
Yes, she has some market risk and probably even a little inflation risk. But it sounds like those are under control and well-managed risks. The real risk here is entrepreneur risk. Maybe the buyout offer is contingent on her sticking around for three or four more years in the business. She doesn’t really want to sell as she enjoys it, but 2/3 of their net worth is now tied up in a single business in a risky industry. At this point, a big part of their income and financial lives is tied to the business. She might have trouble going back to full-time practice, and her husband burned a few bridges when he left his job.
Protection Measures
What can they do to mitigate their entrepreneurial risk? There are a few options:
- Pull profits out of the business (rather than reinvesting them) as quickly as possible and invest them in stocks, bonds, and real estate. Once they are financially independent (FI) just from their investments, they’ll still be FI even if the business completely collapses.
- Sell the business and take all that money off the table. This would make them FI, although it would crush their dreams of making the business even bigger. Plus, it would not be nearly as much fun without the control they have enjoyed.
- Sell part of the business by bringing on some investors. Some of that money could be used to “take money off the table,” while another chunk of it could be reinvested into the business.
- Buy some “key person” insurance in addition to her personal life insurance to further protect the business.
- Borrow against some of the assets in the business and invest that money into the stock, bond, and real estate portfolio.
- Restructure the business a bit to provide some asset protection for it from her clinical practice.
- Hire out some jobs in the business to allow her to pick up more clinical hours and diversify their income.
Luckily for Wanda, this is a great position to be in, but that doesn’t mean she can’t minimize her biggest risk by some combination of the above.
What do you think? What are your biggest financial risks right now? What are you doing to protect yourself from them?
[This updated post was originally published in 2020.]
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