Frugal Living & Managing Risk, III

Two days ago, I wrote about the issue of long term risk and how two academics are suggesting that the long run may be riskier than the short run. Yesterday, I shared my own experiences with balancing my goal of frugal living and risk. Today, I'll discuss my understanding of risk and how this influences my savings and investment strategies.

Managing risk is a big topic in many financial planning magazines, sites and blogs. I am particularly intrigued by the lead article in April 2009 issue of Money Magazine, The 7 New Rules of Financial Security, which seeks to "examine the flaws in the conventional wisdom" about money management and "propose some new rules for the road ahead." Here are the 7 Rules, as excerpted from the online article:

RULE 1: RISK
Old Thinking: If you can stomach the ups and downs that come with risk, you'll be rewarded.
New Rule: Risk isn't about your stomach. It's about making or missing an important goal.

RULE 2: CASH
Old Thinking: Keeping enough money in ultrasafe accounts to cover life's emergencies, but no more
New Rule: Rely more on cash can rescue you in an "asset emergency."

RULE 3: HUMAN CAPITAL
Old Thinking: The longer your time horizon, the more stocks you should own.
New Rule: Time isn't everything. You must also consider your earnings potential.

RULE 4: BORROWING
Old Thinking: Borrowing sensibly is a good way to build wealth.
New Rule: Borrow cautiously. You have to worry about the other guy's debt too.

RULE 5: HOUSING
Old Thinking: You can expect your house to appreciate handsomely over the long run.
New Rule: Your home won't make you rich. But it is an important savings tool.

RULE 6: DIVERSIFICATION
Old Thinking: A diversified portfolio lowers your risk.
New Rule: Diversification won't always save you - and you need more of it than you think.

RULE 7: RETIREMENT
Old Thinking: Retiring early is a prize.
New Rule: Retiring early is a problem.

Like the Money magazine article, I have also articulated my own rules for frugal living and managing risk. As I mentioned in Part II, my frugal nature and understanding of risk management have been shaped by the collapse of my parents' finances in the 1980-1982 recession. My dad was gungho and wanted to build up the family's financial wealth in a get-rick-quick approach by putting 100% of the family's investments in aggressive growth stocks. My family middle-class wealth was wiped out by the 1980 recession, and my parents have been very cautious ever since. Unlike some of my uncles and aunts, who lost a huge chunk of their investments in the 2008 crash, my parents, now comfortably retired, actually came out unscatched, since the bulk of their investments are in FDIC-insured CDs and high yield savings.

My own views for managing risks are as follow:

1. My overriding life goal is to live frugally and save sufficiently for my retirement especially since I no longer have the safety net of a traditional defined-pension.


2. I do not count on job security and work on the assumption that I can be laid off any time. In view of the deep-seated nature of the 2008 recession, I expect that I will take longer than normal to get a new job or may have to accept a job with lower pay and benefits.


3. My views on risk management are shaped by #1 and #2 above. If I know that my own job is not secure, then I should not take on unnecessary debt and make risky moves.


4. I argue that traditional financial planning advice assumes job security, so that one could ride out the swings in one's stocks and property investments by relying on one's regular salary. But what if there is a triple whammy: huge losses in stocks, property values and jobs?


5. First, I manage my risk by having a sufficient emergency fund in case I am laid off tomorrow. My goal is to have an emergency fund that is sufficient to cover 12 months' worth of expenses (much higher than the 6-9 months advocated by financial planning experts, who in my opinion, never anticipated the Great Recession of 2008). As I mentioned previously, I keep my emergency fund in an HSBC High Yield Online Savings. While I'm not happy about an annual interest rate of 1.65%, the main goal of my emergency account is liquidity.


6. Second, I manage my risk by investing my 401k in a stable value fund that is offered by my plan administrator. I contribute the maximum amount to get the employer matching contributions. As far as I am concerned, this is free money that my employer is giving me. Management is discussing the possibility of temporarily ending the employer match, in addition to other options like pay freeze, etc. Hence, the preservation of principal is important. I don't mind a 5% compound interest on my retirement investment, rather than seeing a 40%-50% plunge that my colleagues have seen, when they invested aggressively with the goal of early retirement.


7. Third, I manage my risk by living frugally and not taking on unnecessary debt. The only debt I have is a 30-year fixed mortgage on my home and student loans. I have no credit card debt, as I pay off the balance in full every month. I'll blog more about my credit card strategies in a future post. I have no car loan, since I bought my car with cash. In other words, if I want something, e.g., a car, I save up in full and then go out to buy the car. This is not just being frugal on my part, but it also forces me to think whether I truly need something, thereby avoiding impulse purchases that I would regret later.


8. Finally, I manage risk by investing cautiously. At this moment, I put my money in high-yield online savings and online CDs. As I mentioned yesterday, I would rather be the cautious and plodding tortoise that wins the race rather than the overconfident high speed hare that falls asleep and is left behind.