Risk

It is not surprising to us that risk management is one of the most frequently Googled wealth management terms by individuals.   When wealth has been built up over many years it is understandable that an individual would be concerned about protecting that wealth. After all, people tend to have accumulated most of their wealth by the time they close in on retirement and would find it difficult to rebuild lost wealth should an impairment occur at that stage in life.  This article looks at the most common types of risk to wealth that an individual can face and discusses ways to best manage those risks to protect and preserve the wealth that has been built up.

Risks come in many different forms.  Some risks can be controlled by the individual while others are totally beyond their control and can only be managed through awareness of the  risk and the taking of mitigating steps that are available.  Several risks are related to investments in assets such as stocks, bonds and real estate.  Others are related to unexpected events such as a death or disability, or from liability and litigation.  Following is a list of some common risks that will be discussed in this article:

• inflation risk
• concentration risk
• valuation risk
• liquidity risk
• liability risk
• unanticipated events risk

Inflation is very destructive although it has been well controlled in the developed world for most of the past 30 or 40 years. It has been a wealth destroyer at various times notably in Germany during the 1920s and in Argentina and other South American countries over recent decades.  Inflation does not wipe out the face value of an asset, rather it reduces that asset’s purchasing power. Think of it this way, $100 today will buy you ten loaves of bread and ten cartons of milk. In 10 years after a period of hyperinflation, $100 will buy you one of each.  You still have your $100 but it will only buy you one-tenth of what it did 10 years ago. While some inflation is considered healthy, excessive inflation is very damaging to an economy and to an individual’s wealth.  The worst assets to own during periods of rising inflation are cash and fixed-income investments.  Other assets such as real estate, equities and commodities do better. 

The second risk which can also be very detrimental to an individual’s wealth is concentration risk. What it means essentially is putting too much all your wealth in one thing.  We’ve all read about gold bugs and speculators who truly believe that a particular investment is a sure thing. They put all their money into this sure thing only to see its price collapse. It’s happened many times in the past to many different investments.  Think U.K. railway stocks in the 1800s, the nifty fifty stocks in the 1970s, Nortel and other technology stocks in 2000, Japanese real estate, U.S. financials and residential real estate in the years leading up to the Great Depression of 2008/09.  These were all great investments for a period of time, and it would have been understandable for an investor to want to participate.  However, the reality is that no one can predict the future and any one asset can have its value wiped out by something that was unforeseen.  If someone put all their money in technology stocks in March 2000, they would have seen a 75% decline over the next year and it would have taken 14 years for the investment to recover its lost value.  However, if the investment in technology stocks was only ten per cent of the individual’s wealth the decline in their net worth would have been much less.  Diversification is a cornerstone of any wealth management approach.

The next risk is valuation risk which is the risk that arises when an asset owned is priced at a level that raises questions.  Often valuation risk and concentration risk are seen at the same time.  For example, an investor saw how much oil stocks were appreciating and read the media hype talking about the further appreciation in store for oil prices.  Already pricing in rosy expectation for future oil prices an investor puts half their portfolio in three leading energy stocks.  Six months later oil prices started retreating and oil stocks followed.  Stung by the loss the investor sells his energy stocks for a significant loss with his wealth taking a big hit.  Valuation risk can be difficult to spot.  Often an overvalued asset is significantly hyped by other investors and its previous appreciation has attracted a lot of attention.  Media pundits will seek to justify the seemingly extreme valuation with talk of a new paradigm and extraordinary future growth or price increases.

Liquidity risk means not being able to convert an asset into needed cash to meet an upcoming obligation.  It most commonly affects business owners but can also affect individuals who need to liquidate an asset to meet living expenses or to make payments on a liability.  Imagine losing your job during a recession.  You’d put all your wealth into a multi-unit apartment limited partnership and there was no mechanism to cash it in.  You were unable to raise funds to meet your mortgage payments and fell behind, risking foreclosure.  One commonly quoted piece of advice is to maintain 3 months of living expenses in cash or liquid investments whose value is stable.  Also, not over leveraging oneself or a business is prudent.  Good times don’t last forever and maintaining a strong personal or company balance sheet is vital to making it through challenging times. 

When wealth has been accumulated by an individual or a company that wealth becomes exposed to various liabilities that could occur from a number of sources.  For example, a guest at your home has an accident and sues you.  Your restaurant serves someone with a severe allergy to shellfish, and they die.  You are the director of a company whose bookkeeper embezzled funds by not remitting HST for several years and CRA is suing the Directors to recover the funds.  Liability risks such as these and many others can be managed through the use of insurance protection, family trusts, segregated funds offered by insurance companies etc.  However, while the vast majority of individuals and businesses do hold liability insurance it is often the case that the insurance coverage is not enough, or certain risks are not covered at all. 

The final risk we highlight is the unexpected event that threatens a business or individuals’ income or a family well being.  The most common event is the sudden death or disability of the business owner or family bread winner.  In the case of a business the loss of the key person can threaten the very survival of the business which could be a major part of the deceased’s net worth.  The protection of a business can be addressed through adequate key man insurance and explicit instruction in a will that can allow an executor full powers to move expediently to preserve the businesses value.  Individuals tend to be under insured and some have only life and no disability.  For young to middle aged persons basic term life insurance is very economical and even self-employed persons can disability coverage in most cases.  A regular review and update of insurance coverage with an experienced and objective agent is recommended to keep up with changing life circumstances.

As this article has discussed, risk management is something that individuals and business owners should pay attention to.  Risks to wealth can arise from various sources but in most cases can be well managed through prudent and diligent efforts.  A qualified and experienced wealth planner can assist with the risk review and making necessary changes and in many situations will recommend consulting with various experts in fields of legal or accounting where specialized help is warranted.