There is risk to everything. Even the things we believe are low-risk have an opportunity cost, which is just another type of risk.
Your personal level of risk is a huge determinant of your financial behavior. Here are some places you can put your money, starting with the least-risky to the most-risky:
- in-house
- checking account
- savings account
- money market account
- US treasuries/CDs
- bond funds
- stock funds
- individual bonds
- individual stocks
- leveraged assets
Now, clearly keeping money on-site is subject to theft and fire, but at least it can’t be seized or frozen by the government (easily) if the US ever turned Greek on us. And you wouldn’t think of Savings Accounts as very risky, because they aren’t, but they sometimes have withdrawal restrictions, such as X number of withdrawals per month, or $Y per day.
But without diving into all of these things or defending the somewhat loose positioning I’ve given them, how does risk affect human behavior?
First of all, we typically avoid the things we don’t understand. Most people do not understand investing well, or at least they do not understand how to set up a brokerage account and how to buy securities. Several years ago, I used to think that investing HAD to be done through a broker, so I completely avoided it because I didn’t know who to trust and, as an introvert, I really didn’t want to set up an appointment to talk with a stranger about my finances. It turns out that setting up an account online with Vanguard was as easy as setting up an online checking account. Setting up a Roth IRA online is also hella easy. So now I invest in mutual funds.
Every person’s natural level of risk will be different, so it doesn’t make sense to recommend the same thing for everyone. I have one friend who has substantial amounts of cash saved up, but he has alluded on several occasions (intentionally or not) that all of this sits in the bank. Partly this kills me because if he had begun investing 5+ years ago, that money would have grown enormously. Of course, hindsight is 20/20, and there was never a guarantee of that growth. Being a risk-averse person, he just chose to keep it in money. Even a Money Market account would have grown a little! But this doesn’t really matter: he chose what was comfortable to him. Even though his money has technically lost value due to inflation, he’s still a lot better off having the money than not. Let’s just imagine he has $100,000. I’d rather have that $100k than $0 today, and I’d rather have that $100k ten years from now than $0 ten years from now, even if the purchasing power is less. Does that make sense?
Oh, and a word on inflation: you only have to be concerned about inflation if the things you buy are subject to inflation. There’s a lot of fear mongering over this, but it’s not like, come January 1, everything you buy in the store has suddenly gone up 2.5% or 3% or whatever the Fed tells us was the inflation for the year. It doesn’t really work that way. Contracts happen, price negotiation happens, process improvement happens. Some things adjust faster than others. People don’t like spending $60 on a video game today, but video games were often $60 ten years ago! Technically, they have gotten cheaper. Books on the other hand, well, a normal paperback is around $15-18, while a hardback is typically around $25-30. This seems insane to me because I remember when paperbacks were $8 and hardbacks were $12. But inflation does take it’s toll on these items. Plus, there are fewer economies of scale as digital downloads have cut into the market for physical books, so I would imagine higher prices have to be charged to offset the cost of printing.
We also tend to avoid investments that we ourselves or others we know have been burned by. My parents lost their house in 2007 due to a really bad combination of things both inside and outside their control. So when people tell me I should buy a house because “housing always goes up!”, I kind of want to punch them in the face. They won’t lose many memory cells because they clearly don’t have any that go back 10 or 15 years. I’m kind of kidding, but I’m also not. So I’m very cautious about housing, and I also realized it just isn’t the place I want to park my money at this point in time. This could be similar to people who avoid the markets because they sold at a historic low and lost a ton of money. There could be people who swear off starting a business because they once got burned by a bad business partner.
It’s perfectly rational to avoid what has hurt you in the past. There’s a bulk of psychological research on this very subject. But I haven’t completely sworn off home ownership. I think it’s important not to swear off the things that have hurt us or others we know. Especially with financial systems, what hurt others won’t necessarily hurt us, and what helped others won’t necessarily help us. This is why ‘finance’ is such a huge and messy subject. I also believe that the more education people have about personal finance, the more likely they are to accurately assess their own levels of risk. Hence, why I talk so much about money. Knowing how money works is very empowering.
So what do we do with all of this?
To start, I highly recommend people to have an Emergency Fund. I first encountered this through Dave Ramsey, who put together Seven “Baby Steps” to financial peace. I’m not a huge follower of Dave these days, but I’m a strong supporter of the first steps, and Step 1 is to have $1000 in an Emergency Fund. Step 2 is paying off all non-mortgage debt, and Step 3 is funding the emergency fund to 3-6 months of expenses.
I’m a fairly risk averse person. I had about $3,000 in my emergency fund before starting to tackle my student loans, which were my only form of debt. I had just started my career in software and was scared to death I wasn’t cut out for it. But it turns out that I really was. And how much you have in your emergency fund really should reflect a consideration for how secure your job is. Is your job cyclical and unpredictable? Pack that emergency fund pretty high. Is your job cushy, difficult to get rid of, or are you highly skilled in your field? You can probably keep a lower emergency fund.
I tried to put a cap on my emergency fund once it was high enough. If you’re familiar with the Enneagram, I’m a total 6. Security is a big deal to me. If I had the option, I’d have $50k sitting in a money market account, causing security. But the reason for the cap was largely a faith-based decision. It came from realizing that I can’t save myself with money. Money has tremendous power and it’s important to have it set aside from life’s many requirements, but I knew that if I left my desire to decrease risk unchecked, it could easily turn into a black hole, and no security would ever be enough to fill that. So the rest went to investing, which is riskier. Now, I do plan to increase my car savings, which is a separate account I use for car repairs and the next car, but I’m hoping I won’t actually need that for a long time. And one day I will increase the emergency fund as well, but the message is that I’m deliberately holding back on this to keep in mind where my real security comes from.
But you’ll notice that no matter how high or low you set your emergency fund, your resilience as a person is dramatically affected by your savings rate. Sometimes I think people are terrified of bad things happening to them financially because they think that there’s no road back up from that. This is a form of poverty thinking. This is only true if the responsible handling of money isn’t part of your character. I have high savings, but even I fear this at times. If the responsible handling of money is part of your character, you can always rebuild. The voice inside of us saying that we can’t rebuild is the voice of victimhood. I get it, I really do. But we don’t have to be victims. If you build the habit of not spending all of your money and savings as much as you can, a lower paying job is not going to beat you down, and a higher paying job is not going to make you soft. Empires rise and fall, currencies rise and fall, but what you can consistently do is choose how you handle the ‘value’ that has been made available to you.
This is a long process, but is totally worth it. In lieu of making more suggestions (and in the absence of better things to say…), here’s a breakdown of my own money buckets, from least risky to most risky, that might help others to formulate their own strategy:
- One month’s worth of grocery money, denominated in physical cash on-site
- $1,000 in a savings account (kept there at all times for quick access)
- HSA, full health insurance deductible available in cash via debit card, the rest is invested
- 5-6 month emergency fund in Vanguard money market account
- Roth IRA (maxed out for 2018)(contribution money can be withdrawn tax and penalty-free)
- 401k, mostly taxable if withdrawn
- employee stock grants
By the way, the title of this blog doesn’t actually refer to financial risk ;). That’s a story for another day.