Risks in life planning

Life is a risky business

• Insurance as a risk management tool
• The essence of insurance
• Non-insurance risk strategies
• Dealing with risks in investing
• The portfolio approach
• Active/Passive management debate
• Required skills and abilities
• Do-It-Yourself opportunities and considerations

Life and health insurance can help achieve and maintain financial health, a basic component of protecting your health in the broad sense advocated by the WHO. Financial stability or financial health of anyone can be affected by investment risks as well, quite irrespective of potential illnesses, injuries, or untimely death.

Insurance as a risk management tool

There are many misconceptions around insurance, and a lot of emotions. However, the best is to deal with it calmly and sensibly. As a matter of fact, often insurance is the best way of dealing with financial risks for the individual, the family or the business. It is also true that life and health insurance can be used either wisely or foolishly.

The essence of insurance

Shocking it may sound but some people quite misunderstand what insurance is about. I have been approached numerous times for help with insurance when it was too late. These people mistook insurance as some kind of philanthropic source of cash to apply for when in need. Though related to human suffering, it’s not about charity: it is a rational, money making business. With almost anything else, one can postpone buying until there is a need for use; with insurance, buying is not an option then: you can apply and pay for it only in advance.

Any kind of insurance is basically a risk-sharing arrangement among a large number of people who would be much more financially vulnerable without the insurance industry organizing this ‘pool’. Long gone are the days when closely knit large families and small communities of people were the norm to help those stricken by injury, sickness, or the loss of the breadwinner because of death. These kinds of help, together with assistance from the government and society at large can be life saving, but probably cannot provide a life-style even remotely comparable to the one that is realistically achievable to the great majority of people through insurance.

Non-insurance risk strategies

All the above is not to say, of course, that insurance is the only way of managing risks in our life, or even that it would be the most important part of it. Being cautious, avoiding dangers, leading a healthy way of life are fundamental, since no money can bring back or fully substitute life or health lost. Any sensible person takes precautions, but to varying degrees we cannot avoid risks, or even do not want to give up certain things that are risky. Since all these unavoidable and/or voluntarily taken risks have financial consequences, one has to be equipped with proper financial tools as well. Insurance is the best tool for such purposes. A general piece of advice in the debate about the necessity and usefulness of insurance is that it often does not make much sense to pay for insurance against high-probability but financially manageable losses. On the other hand, it is much more reasonable to insure against low probability but potentially devastating losses.

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Dealing with risks in investing

Risk is one of the key words in the area of investing too. Of course, when one plans a good life and financial stability, there are many other things as well to consider (starting positions, personal and income goals, saving rates, various given or voluntarily espoused liabilities, dreams, etc.), … but the issue of risks is there always as well. I’m talking about the risk of low or uneven investment returns, or perhaps simply an unfortunate temporal pattern of those, as well as the risk of loss of purchasing power due to inflation, the risk of losing the capital invested, the risk of loss due to changes in the exchange rates, and so on.

Portfolio approach

Yes, risk is a four letter word, but it doesn’t mean that it should be avoided at any cost. The most typical example for that happening is when investors shun certain available choices, … whereby often ensuring the near-certainty of missing their life goals. Instead of avoiding it altogether, the better approach to risks is trying to understand, manage and monitor them. The key investment risk strategy is diversification; in other words, the good old ‘balancing act’, ‘middle of the road’, or ‘eggs in more than one basket’ principle. What can elevate diversification above these mundane admonitions, and distinguish a hodgepodge holding of assets from a professionally designed and maintained portfolio, is knowledge about the nature of the risk characteristics of the components, plus their interrelationships. It’s a bit like preparing a meal: it matters what kind of ingredients you use, in what proportions, and often even in what kind of way or order you combine them. Similarly to the uniqueness of a meal, achievement of proper diversification is partly a matter of very personal factors (psychology, philosophy, discipline), but it’s also influenced by knowledge, understanding, and expertise, … either own, or hired.

It goes without saying that selecting good quality ingredients for your investment soup can greatly improve the chances that the soup will be tasty and healthy. A most frequent problem with picking investment assets (especially with stocks and mutual funds) is that people devote too much of or all their attention to it, and as a result, they neglect the other fundamental aspect, namely the ‘cooking’, that is the combination of the ingredients, … in other words, the portfolio. There are common psychological tendencies that make us inclined to devote more attention to losses or disappointments than to gains or better than expected outcomes. It is advisable to consciously fight these tendencies, and often remind ourself that what really matters is not how this or that particular investment performs, but the performance of the whole portfolio.

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Active/Passive management debate

Closely related to the above issue is the on-going debate between proponents of passive vs. active stock selection (or, in more practical terms, between stock picking vs. index investment advocates). Both sides have good arguments, but while the ‘indexers’ seem to have stronger academic, statistical, or rational arguments and evidence, the ’stock-pickers’ undeniably have psychology and ignorance more on their side: it just goes so much against ‘common sense’ (an important but also dangerous notion itself) to accept the inescapable limitations of stock-pickers or active money managers. I think, we do not necessarily have to take and either-or position in this debate: we each can have our position at some point between the extremes on the spectrum. To me, e.g., a 50% active / 50% passive investing position is an acceptable compromise. What is more important than these percentages, I believe, is that we are familiar with the debate, the characteristics of the respective outcomes of each of these two alternatives, and that we don’t loose focusing on the whole portfolio.

Required skills and abilities

In addition to familiarity with financial terminology, and a few basic rules and products, a general awareness and some understanding of psychology, as well as trends in the economy, global affairs, health, technology and demography fields, among others, support better dealing with investment risks. It may sound unwarranted or simply silly to advocate breadth of knowledge, understanding, and awareness; the advantages of specialization and focus are usually emphasized, … but they are often overrated. I find it very telling how Warren Buffet, perhaps the most highly esteemed investor of our era, remembered his best teacher and mentor, Benjamin Graham. Graham, writer of The Intelligent Investor and Security Analysis, is considered by many others as well to have been the top authority in investing. According to Buffet, “A remarkable aspect of Ben’s dominance of his professional field was that he achieved it without that narrowness of mental activity that concentrates all efforts on a single end. It was, rather, the incidental by-product of an intellect whose breadth almost exceeded definition. Certainly I have never met anyone with a mind of similar scope.” Of course, nobody can be a real expert in all these fields, but some relevant expertise and skill level is achievable with effort and the right attitude.

Some level of quantitative skills and understanding of probabilities, statistics, and randomness are also advantageous. Appreciating the mathematics of long term processes is not obvious to anybody without learning. The level required for successful investing is not rocket-science, still most people just ‘do not feel’ what a difference it makes if, e.g., we calculate with slightly different rates of compounding or inflation, or how much it takes to accumulate a fund large enough to provide a desired level of real income through many years. Spending some time with on-line calculators may be a useful way of getting the necessary attitude, feel, and appreciation at least.

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Do-It-Yourself opportunities and considerations

Some basic knowledge of the main issues, concepts, and relations of financial matters is very important for everyone. You should not expect to pick up all the nuances and tricks about insurance or investing from the perusal of handy materials or books, but spending some time with them is certainly rewarding. There are also courses anyone can take, not to mention the infinite amount of information available on the web. In fact, today the main problem is not the lack of information, but the ability to correctly select, understand, interpret, and apply it. If you do not take the pain to learn at least the very basics of finance, then you either cannot deal with it at all (a poor, too risky choice) or you have to blindly trust somebody whose interests and capabilities are not necessarily to your best advantage. Instead of these extremes, I advocate ongoing learning, and the sensible (in terms of both kind and extent) use of, and cooperation with professionals. Since at the end of the day decisions are, despite all the thriving for rational information processing, emotionally loaded, people should not forfeit (or relinquish their responsibility for) making the final decisions for themselves.

Costs are obviously vital factors regarding financial decisions. An important component of the learning process is to get familiarity with them, both the obvious and the more or less hidden types. Many people neglect these, and pay too much for either products or services as a consequence. Others try to go to the other extreme, believing perhaps that saving on costs is the only important factor under their control. Don’t throw the baby out with the bath water! It is important to emphasize that costs can be realistically evaluated only in comparison with services, and potential benefits and returns. One should not forget about opportunity costs either: the risk of getting less in return for a planned course of action than what we might expect from an alternative action or decision. It is also important to look at the often significantly differing costs of same or similar products or services available from different sources. Transparency of all costs and benefits is vital if we try to deal with financial risks rationally.

Because of various reasons (differences in availability of information, role of emotions and confidentiality, legal aspects and regulations, etc.), one can argue that the opportunity for relying less on professionals is better in the area of investing than in insurance or comprehensive planning. Some Do-It-Yourself-ers, although probably fewer than (or not the same as) those who actually espouse this strategy, can even leave out middle men from investment product purchases completely. Dealing with investments can be perceived as more exciting or ’sexier’ even than dealing with insurance, e.g. At least some reliance on outside experts is probably always warranted in the area of comprehensive planning, and real Do-It-Yourself in insurance is hardly ever a good choice or even possible.

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