Managing Risk In Personal Finance

If you owned an oil company and you had the technology to drill offshore at depths of a mile or more would you apply it? Up until April 20 you would have thought the rewards justified the risk. However, the events of that day and the aftermath will have permanently changed the industry's approach to managing risk.

The risks may have seemed small. Deep sea drilling has been going on for years. Thousands of rigs are operating safely all over the world, 500 of them in the Gulf of Mexico alone. Major oil spills are fortunately few and far between. So was the risk worth taking? In retrospect no, but being a world leader BP could not stand by and watch other oil giants take the lead. Were they covered by insurance? The answer is no; the cost of insurance to cover this kind of risk is so high that most companies choose to self-insure.

HOW DOES THIS RELATE TO PERSONAL FINANCE?

It is a very close analogy. How often have we taken personal, career or investment risks, confident we will reap rewards while keeping our fingers crossed that nothing will go wrong? And how often have we saved a few dollars by neglecting to take out insurance?

In our quest for wealth we too are tempted to take on risks in the belief that we will never suffer our own well blow-out. And just like the big oil companies we may reckon we can save money on insurance. Many expats believe they are adequately covered by their companies. This usually means two or three years' salary. But if you are supporting a wife and young children that money could be exhausted in five years. To generate an income of $50,000 a year you need cover of at least a million dollars.

Most expats in Jakarta work for large companies that cover the cost of medical insurance. Not so in Bali where most have to fund their own cover. Many decide they do not need it. I have known several cases where this has cost lives, all for the sake of a couple of hundred dollars a month. Some choose to retire in Indonesia. Unfortunately insurance premiums become very costly as you get older and you may have to take the decision to self-insure. But unless you have accumulated significant wealth this requires an acceptance of local care or a return to the gray skies and social welfare of the homeland.

WHAT ABOUT INVESTMENT RISK?

First of all, there is no completely risk-free home for your money. In medieval times you might have kept it under the mattress. Not a good idea in face of fire or theft. We all thought money was safe in the bank until the financial meltdown in 2008. Thousands of people lost money in accounts that exceeded guaranteed levels. At one stage there was the possibility of a complete collapse of the global financial system. Had this occurred all bank accounts could have been wiped out. Stability has returned but there is a new threat of contagion in Europe as several countries start to pay the price for their over-spending. There remains a small possibility of another global banking crisis.

SO WHERE SHOULD YOU PUT YOUR MONEY?

International banks are still amongst the safest places, but keep in mind the limits guaranteed by the respective jurisdictions. Government bonds are generally safe if they are in the currency of the respective country as governments can always print more money to meet interest and capital repayments. There is still a risk of capital loss in the short term and loss in purchasing value in the long term.

What about stocks? Over time these have proved to be the best way to see your money grow in real terms, since you can enjoy both dividend income from the profits and see the value of your shares rise. This did not work however from 2000 to 2009, a decade when western stock markets untypically fell.

What about property? Ideally everyone should own a home but going overboard with real estate investments has proved ruinous for many. When you need cash in a hurry you cannot sell a bathroom.

Is gold the answer? Certainly many pundits today are recommending it as a hedge against uncertainty and currency risk. The gold price today is around $1,200 an ounce and some think it will rise to $2,000 an ounce within a few years. But before you rush out to invest in it you may wish to bear in mind that in the early eighties gold fell from $800 an ounce to around $300 and stayed close to that figure for a quarter of a century! Nevertheless, gold and other commodities should be considered as important risk-reducing long term investments.

TIME AS A FACTOR IN RISK

Cash in the bank is most certainly low risk in the short term and everyone should maintain adequate reserves, but holding surplus cash for the long term entails two risks, one is currency, the other is loss of real value through inflation.

Many people tell me they do not wish to invest in stocks because they are risky. I will agree with them if their investment timeframe is a short one. But holding a wide range of stocks for the long term is relatively low risk and you have a better chance of seeing real growth. Some say the stock market is a casino. To a degree that is true for people who like to 'play' the market. At the other end you have long term 'buy and hold' investors like Warren Buffett, who became one of the richest men in the world by investing, not gambling. But even he has had to take risks and endure setbacks on his road to success.

THE BIGGEST INVESTMENT RISK OF ALL

It should already be clear that the biggest risk of all is putting all or most of your eggs in one basket. Many Enron employees and pensioners lost their life savings when their company went down. More recently we have seen a collapse in value of BP shares. They may recover in time but the fall has made a big hole in many portfolios and pension schemes. These are reminders of the importance of diversification.

Running one's own business offers the prospect of far greater wealth than can be attained in a salaried job. But success comes to perhaps no more than one in five. The remainder languish or disappear into oblivion. The key to managing risk if you are running a business is to keep ample assets, including a private pension, separate and ring-fenced from the business. That way, if the business collapses you still have a life. Putting all your faith and money into a venture may bring riches but could also be a quick road to ruin.

THE SECOND BIGGEST INVESTMENT RISK

This is perhaps the risk of doing nothing. Many let their finances tick along without any aim, direction or advice, taking no active interest in how their investment plans work or how they should be maintained. The financial world is constantly changing and we need to be aware of the changes and how to adjust to them. A good example is the case of the top five managed funds in the UK in the year 2000. Five years later not one of the funds was in the top five. In fact, not one of the funds was even in the top 500!

Managing risk in personal finance requires understanding and involvement. It also means adapting to changes. When I was doing this work in Jakarta prior to 1996 I had never touched a keyboard. That was a job for the secretary. Few of us would survive today if we could not use a computer. I suppose a chimney sweep wouldn't need a computer but then his job has disappeared anyway.

In summary, we have to live with risk in the financial world. We cannot hide from it and if we want to be successful we have to embrace it. The key to success is managing it.