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By LARRY SWEDROE / MONEYWATCH / December21,2012,7:00AM

How to think about risk in

nancial planning

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(MoneyWatch) Bloomberg's Pimm Fox recently asked me how investors should

think about risk. He wasn't referring to your portfolio going up and down. Instead,
he meant how you address the outside factors that could derail your plan, even if
your returns are better than you were anticipating. Here's how you should think
about those outside factors.
Investmentgainsandlosses. Before we get into the other types of risk, let's
have a quick review of the risk of gains and losses. When talking about your
portfolio, there are two types of risk:
Good risk, for which you're compensated through higher expected returns
Bad risk, for which you receive no compensation for taking
For example, stocks are riskier than bonds. No matter how many stocks you own,
you can't diversify away their risks. Because of this, stocks have to offer higher
expected returns than bonds. Otherwise, investors would only invest in bonds.
Why else would you take on risk if you weren't expected to be paid for it? This is
good risk, the kind you're paid to take.

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Bad risk, on the other hand, means doing something like concentrating all your
stock positions in a single sector or country (including your home country).
Economic and geopolitical risks can be diversified by building a globally
diversified portfolio. Since you don't receive higher expected returns for
concentrating your risk in a single country, why wouldn't you diversify that risk?
Longevityrisk. Simply developing your investment plan isn't enough to ensure
that you'll have enough money to fulfill all your financial wishes. For example, you
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How to think about risk in nancial planning - CBS News

run the risk of outliving your assets. Thus, while investing in stocks means you
might lose money, not having a high enough allocation to stocks will likely
increase the risk of not achieving your financial goals -- including not outliving
your financial assets. Annuities are also a way to hedge against this risk, provided
they're properly structured for your situation.

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Liquidityrisk. There are many investments that have higher expected returns
because they're less liquid, meaning they can't be traded or cashed in as easily as,
say, Treasury bonds. It can also mean that trading them means you'll incur greater
costs. This doesn't mean holding them is necessarily a bad thing, but you need to
prepare in case you have a sudden need to raise cash. Do you have access to other
assets in case of emergencies? If not, you may be forced to sell your illiquid assets
at steep costs. Investors should make sure their plan addresses the potential for
unexpected calls on liquidity -- keeping sufficient assets in very high quality, shortterm bonds.

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Inflationrisk.People living on fixed incomes are at a significant risk of inflation.

If the prices of goods rise dramatically and their incomes don't, they then face
difficult decisions to make about what gets cut out of their budgets. Those with
significant exposure to this risk, such as retirees, should favor bond investments
that are linked to inflation (Treasury inflation-protected securities and I bonds)
and/or they should favor short-term nominal bonds. They might also consider an
allocation to commodities, which tend to perform well when inflation is rising.
Lifeeventrisk.Insurance becomes an important part of the equation as well.
Your investment plan isn't worth much if daily life throws you a few curveballs you
aren't prepared to handle. A well-developed financial plan includes a detailed
analysis of the need for protection against various risks:

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Life insurance, for replacing income lost with the death of a breadwinner
Disability insurance, in case a breadwinner can't work
Long-term care insurance, to protect against care costs draining your assets
Property and casualty insurance, such as for homes, cars and boats, and
against floods and earthquakes
Personal liability insurance, including an umbrella (excess liability) policy

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The bottom line is that to develop a well thought out financial plan, it's critical to
consider all of the various risks that could derail it.
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Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored
13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions
and comments expressed on this site are his own and may not accurately reect those of
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