Analyzing Risk for the Average Joe
Do it yourself, because no one else will do it yourself.
Risk analysis, when it comes to finances, can be confusing and it is no wonder that whole industries and academic specialties have evolved around it. It has its own terminology, making it even more unreachable to the average person. However, to avoid making the mistake of a lifetime (such as when you buy a house), it is extremely important to manage your risk yourself.
This article should not be taken as anything but tongue-in-cheek. Lawyers will tell you that you should get professional advice when it’s needed. Do that. This is not professional advice, even in the slightest.
We assume that you will be buying a house, but all investments need to stand up to the same general scrutiny.
Crap and Clay
The first thing needed to assess risk reliably is knowing the truth. The problem is, there is so little of it around, as everybody is out to make his own fortune and keeps all the useful stuff to himself. Most people rely on bluff and lies to achieve advantage. Some people are very good liars and most are less honest than you. The secret to working fact out from fiction is humility. Know your limitations and you will come some way to knowing theirs!
- Don’t believe anything you hear and only half of what you read. Whatever a person tells you that is not on paper is complete rubbish until proven otherwise. This is an eternal truth that nobody seems to remember. Actually, you’re better off believing less than half of what you read. The sad thing is, most paper has so much crap written on it that it can’t even be used as toilet paper.
- Don’t trust people from a culture you don’t understand. No, this does not mean racism (although it exists, for some reason), but knowing the limitations of your insight. In your own culture you will have a reasonable understanding of the kinds of people that are typical swindlers, the usual lies people tell and so on, but other cultures will have their own set of tricks, coated in smiles and politeness. Instead, get to know the culture beforehand, or at least assume the other person is a lying, scheming scoundrel and then be pleasantly surprised. Industries have their own “culture” too – be warned.
- Corroborate any factual claims. When reading anything, separate fact from opinion. When reading product information (such as for a home loan, or a brochure advertising an investment strategy), underline what you would consider factual, and ignore the rest. Then go and find the same information by another route, such as at a competing institution or the Internet. If you don’t believe me, then go check yourself!
- What’s the catch? Everything has a catch. If you there is no catch, it means you haven’t looked hard enough.
- Get some kind of independent opinion. Get a market valuation of the property if you can afford it, or find out how professional investors find out what things are really worth. Don’t trust anything that comes for free and be careful what you pay for. If you don’t think it’s worth doing, then the property you are considering isn’t worth buying. Don’t forget that most people just fly by the seat of their pants and in many cases nobody does proper “due diligence”, even the investment companies with the glossy brochures. In most situations (not just investing), everybody assumes that everybody else checked. That’s why things go wrong. When you read an appraisal, again, underline the facts and discard opinion.
- The secret of a Ponzi Scheme is getting out of it before everyone else does. Better still, recognize ponzi schemes (and schemers) by reading about them so that you don’t get involved in the first place.
Secondly, work out how much you can gain, how much you can lose and how much you can afford to lose.
- Family budgets are overrated. Sure, go ahead and do one, but chances are you already know what you need to know. It’s easier just to look at your bank statements. If you are saving a hundred or two hundred dollars a fortnight, then that’s where you’re at financially. If you say to yourself “I’ll give up smoking and save $50 per week” you are kidding yourself. Sitting down and going over earnings and spendings will show up a few embarrassing truths, but expecting yourself or others to make major lifestyle changes to save money is just not going to happen, at least not easily. Try to save money, but assume that you will fail when doing calculations. The cost of making financial sacrifices can be greater than it’s worth. Being too much of a Scrooge will ruin your marriage.
- Assume that your income will not rise. If you make purchases on projected income (even if it’s part of a contract), you are taking an unreasonable risk. You might be wise to make contingency plans in case your current income falls, even to zero. Everybody is an optimist and it’s always someone else who has the accident and ends up disabled. Sometimes all you will be left with is first dibs on parking spaces if you don’t plan ahead.
- Assume interest rates will rise. Take the record highest interest rate for your country for the last century (something like 20%) and add a couple of percent. That’s how much interest you have to be able to pay, if you wish to take out a loan. When banks raise interest rates, they are going in for the kill, at which time they have no intention of letting you off the hook, even for one missed payment. If you think you can trust your bank manager, be assured, they will have replaced him in time to fleece you. Baaaaaa!
- Assume your asset won’t appreciate. It probably will, but it might not. Things which can cause this to happen include closure of nearby industries, discovery of toxins in the soil, some kind of disaster not covered by insurers, war, etc. Therefore, think carefully about these kinds of bad luck beforehand. Depressing, isn’t it? The good news is that most things with a real meaning (such as a roof over your head) keep their value over time. If the rent that is collected on a house pays a food bill, it probably will keep paying a food bill a generation or two from now.
- Never take risks on top of risks. If you borrow to buy a house, then use the house as collateral against more borrowings, you are crazy. There is no limit to the imagination when it comes to these things, but watch out for them. People do this more often than they care to admit. Even banks do it, as it happens. But they are stinking, scheming, lying, shifty and crazy.
At this point, calculate for a given purchase (assuming a house), how much you can afford, given your existing budget, your existing income and the worst imaginable interest rates. It has to be said that you do need to look at all the extra costs associated with the asset beforehand too, such as land taxes, council rates, insurance, cost of maintenance, repainting, repairs, etc. It’s probably a lot more than you anticipated.
Then calculate how much you can earn from the investment. Houses bring rental income. Farmland needs to be worked and this is a big undertaking, but fields of grass can be let out to other farmers. Other investments such as shares earn very little for the amount of money put in them and, contrary to popular belief, they are not “easy” and in most cases are the same as betting on horses. Most people believe that the money in shares is made by buying low and selling high. The problem with this assumption is that there is nothing behind it apart from “market sentiment”. Unless you have insider information, you are ultimately going to be one of the people who loses his money so that some faceless Madoff-type gets rich. Of course before that you will get a few winnings yourself, just like at the casino, until you lose sight of the shore of sanity and one day go in all-or-nothing.
Calculate how much you can lose. Houses can burn down (and the insurer will never give you back the real cost of rebuilding), land can be “compulsorily acquired” to build a highway, and companies on the stock exchange can evaporate overnight. With houses, having people inside means that someone other than yourself stands to lose by burning it down, plus you can put in safety equipment and do other things to reduce the risk. It’s a very rare event. With land, a bit of research and getting to know people at the local council can make it a very safe way of investing. With shares, there is basically no way to assure that you won’t be left totally broke.
Make plans to manage the risk. Do not let the total destruction of your main investment be the undoing of you. Diversification is generally a stupid thing to do because you end up putting money all over the place and having no idea of the risks you are taking. Better to do one thing and do it well. Better still to do two things and do them well. Then you are actively managing your risk. It can be as simple as having two houses from which you draw rent instead of one, as long as they are in different parts of town, or different towns.
Making the Decision
Before making any decision on finances, a few things need to be satisfied:
- You need to be sure of how much you don’t know. If it’s too much, then delay your decision.
- The investment has to be better than shoving money into a mattress. In some cases, depositing money in a bank account is worse than shoving it in the mattress.
- You need to be ready to make the maximum estimated loss and have a plan in case this happens (and it can’t be suicide).
- Your decision has to be morally upright. Usury is usury. Theft is theft. Cheating is cheating. Wrong is wrong, so don’t do it.
- You must not rely on tax laws for the viability of your investment. The tax laws change and, just like interest rates, are a trap. Just take Superannuation as an example. The right path is often the most difficult one.
After all of this, it can become quite clear that investment is not easy. Most people work extremely hard to get very little out of life, and there is a small percentage at the top who get rich without appearing to do any work at all. They will probably all go to Hell when they die, and as such their life was not worth living. There is a group in the middle though, which takes what is seen as the conservative path:
Be humble, earn an honest living doing honest work, save your money, invest in real things that people need, have realistic expectations and prepare for the worst.