A financial concept which I find is vastly under considered and under mitigated is risk. In any financial decision you make, there are a variety of things which can go wrong which have the potential to cause you loss. Only once you understand where risk comes from can you make decisions on how to mitigate against risk.
WCGWs and Controls
I come from the financial audit world. I cut my teeth with Ernst & Young for eight years before moving into commercial real estate finance. When we were starting an annual financial statement audit of a large publicly traded company, one of the first things we had to do was sit down with people at the client’s office and walk through each business process. A financial statement audit is to determine whether the financial statements that a company releases to the investing public are free from material misstatement. In order to find misstatements, one must understand where the most likely causes of misstatement come from. We called them our “What Could Go Wrongs”. Maybe a clerk could mis-key a GL entry. Maybe an invoice from a vendor could be missed and not recorded. Maybe the inventory wasn’t counted, causing the accounting balance to be off. Whatever the risk, we needed to make sure that the company had it covered with risk mitigation controls, or else we had to increase our audit testing. There was a lot of statistics involved, but at the end of the day, the lesson was, the more risk exists, the more must be done to mitigate those risks.
This process of evaluating risks and finding controls inspired me to think the same way about my own personal balance sheet. Where was I exposed? Where could I run into trouble if certain things happen? I started to uncover many aspects of my financial picture which made me uncomfortable.
Risks in a financial portfolio
When I started to look into where my wealth was allocated, I realized that I had a heavy weighting in my retirement portfolio to Canadian equities. Being a Canadian, investing domestically was always comfortable because I knew the brand names of the companies in the funds within my retirement account. There was TD Bank, and CN Rail and Suncor Energy. All Canadian household names. But Canada is a relatively minor player in the world economic sandbox. Equity markets are global, and nothing is stopping anyone from investing into the American, European, Asian or emerging market economies. So I started to diversify my holdings across the world to make sure that if the price of oil falls, taking the Canadian dollar and economy down with it, I would have my money invested internationally to offset that dip.
Asset class diversification
Most people put all of their wealth into two main asset classes. The first is what I described above – namely retirement accounts full of mutual funds, Exchange traded funds and bond funds. There’s nothing wrong with this approach – there’s usually great tax advantages to retirement accounts in addition to employer matches. But what happens during global economic recessions when all stock markets plunge? People get very stressed out that their number one wealth building tool takes a big hit.
The second major asset class is the primary residence. Historically, a lot of people have purchased homes over some portion of their life. Every month, a mortgage payment is made that includes some interest expense as well as some principal paydown on the loan. This results in growth of home equity. By the time people retire, they often find a disproportionate amount of their wealth tied up in their home. A home is an asset in that it can be converted to cash if sold, but given you live in it, it’s not easy to do without using debt instruments or (shudder) reverse mortgages. See my article on retiring without a mortgage for more discussion on the pros and cons of retiring with debt remaining on your house. Like a stock portfolio, what if the housing market crashes like it did in 2008/2009 right when you retire? Having too much wealth in your home has its own set of risks.
So you’ve diversified your investment portfolio geographically, but what industries are you invested in? These days, this concept is more important than ever in the age of tech stocks taking over stock indices. The S&P 500 is now dominated by tech – Amazon, Apple, Google, Tesla, facebook and others. It is not wise to have a disproportionate amount of your wealth invested in a single sector. See the 2001 tech bubble as a reference of wealth destruction that can occur. You want to make sure that you place bets on a multitude of industries that have growth potential. In 2021 even though it seems that tech is the only place where growth is happening, look to other industries like hospitality, travel and energy as growth potential as the pandemic wraps up. Keep a portion of your money in anti-cyclical industries that do well when the world is in recession – think McDonalds, Dollarama, Walmart and other places people shop when they don’t feel wealthy.
Some financial assets are riskier than others. Investing in Tesla has a totally different risk profile than investing in an apartment building. One has potential for high growth as well as significant losses. The other is stable, cash flowing and can withstand recessions. Never have all of your eggs in a single risk bucket. Too many young investors want to grow their wealth quickly and pile all of their money into speculative assets like Bitcoin, Tesla and penny stocks, only to have their financial net worth take massive hits when prices fall quickly. Taking some risks is good, and you should, but not with your entire portfolio.
On the opposite end of the spectrum, doing nothing has risk too. Putting your money into a checking account and not taking risk in investment grade assets has the risk of you not being able to ever retire, running out of money and other negative financial outcomes from not being able to grow your wealth to a point where you are financially free. You need risk in your portfolio to grow wealth – it is a requirement.
How do I assess my risk?
The way to assess risk across your portfolio is to prepare a personal balance sheet. What is a balance sheet? It is a financial statement that summarizes all of your assets you own and the liabilities you owe, with the net of the two being your net worth. You need to make sure your assets have diversification and differing properties to them such that no single economic event in any sector, country or currency can have a devastating effect on your net worth. As they say, never “bet the farm” on any single asset.
Looking at your personal balance sheet will also help you understand where your liabilities are, what you incurred them for, and how you’ll pay them off. You want to minimize debts that are not related to investment grade assets that produce income and/or appreciation.
Example Risks of a Rental Property
Risk 1 – Tenant doesn’t pay rent
Mitigation 1 – Solid Rental Contract. Knowledge of tenant and eviction laws. Cash Reserves.
Risk 2 – Roof needs to be repaired
Mitigation 2 – Capital replacement reserves
Risk 3 – Interest Rates increase on the debt
Mitigation 3 – Not over leveraging the property.
Risk 4 – Demand for this type of housing collapses (ie. Covid for downtown multi-family) pushing rent rates down
Mitigation 4 – diversify rental portfolio across demographics/typologies
Risk 5 – Damage to property from fire, flood or earthquake
Mitigation 5 – Insurance
Risk 6 – Jobs in surrounding area collapse (ie. auto industry in Detroit)
Mitigation 6 – Diversify rental portfolio across industry job driver locations
Everything you do has risk. You need to be aware of risks that exist with your financial decisions and how you can mitigate them so that your wealth is protected against economic events outside your control.