There is always risk involved. You can’t be a capitalist only when there are investment profits but then a socialist when you experience losses.
Only focusing on being “debt free” and having an “emergency fund” is like claiming that your favorite team won on defense alone, not needing any offense.
(we are not talking about that kind of risk!)
Comprehensive financial planning
uses cash management, debt, tax-planning, investing and insurance so you use
all resources in the best way over time.
In terms of a holistic plan, amassing
cash is incomplete planning. It deals
very well with market risk, the volatility of the stock market (or any other
capital market). But it gets a zero in
terms of dealing with the inflation rate risk (see notes risks below). The after-tax return on cash is lower than
the rate of inflation.
What if you take a bit more risk and
put money in bonds. Now you added
volatility risk and interest rate risk, but did dampen your inflation
risk. Next, you could add stocks. Now you really addressed inflation well, but
you also ramped up your volatility and increased your liquidity risk. You will need to diversify the stocks and the
bonds, – you can’t just buy Apple stock or a short-term bond fund. Yes, there is so much planning to do.
A good plan will design your cash
management, debt and investment strategies based on your goals. If you can fund all your goals, you need less
return and can take less risk. If you
are far from your goals, you need to judiciously take on more risk.
Okay, then, what if you need an
enormous risk to reach your goals? You can’t
fully amp your investments without going so far beyond your risk tolerance so
that you can’t sleep at night. It would
be better to take the goals down a notch.
You need to cost out all your
goals, then compare those costs to your resources to use them in the best way
to achieve those goals. And at the end
of any plan, this caution should be added:
The single most
important risk to planning is a poorly defined or constantly changing
strategy. You must have a long-term approach
to which you adhere over time regardless of the current favor of the particular
strategy. That will work, while chasing
constantly changing tactics will not.
P.S. – adhering includes monitoring and managing, as forgetting about it
may not work well.
So, evaluate the risks that match
your goals so you can plan well!
Notes on risk:
1. Specific and Non-specific market risk
– are buying a single stock versus buying the entire market. You address these with diversification
(cross-correlations among major asset types reduces volatility over the
long-term without reducing returns) and asset allocation.
2. Interest Rate Risk – is the inverse
relation between the direction of interest rates and the value of a
fixed-income asset as set by the market.
3. Inflationary Risk – is the erosion of
returns in terms of purchasing power due to inflation.
4. Opportunity Cost Risk – is the failure
to invest in assets producing the necessary returns because one chose instead
to remain in cash.
5. Liquidity Risk – is the risk that the
investment chosen is one that cannot be liquidated until sale.