by WWM | Jun 1, 2017 | Diversification
Today we will look at an example of how asset correlations impact portfolio diversification.
Namely the impact on portfolio risk and expected returns.
Correlations in Action
Exxon Mobil is a multinational oil and gas publicly traded company. Let us pretend that your investment portfolio only holds shares in Exxon. A non-diversified portfolio.
The expected return of Exxon is 15% and the investment risk (i.e. standard deviation) is 10%.
You have read that diversifying your portfolio helps reduce portfolio risk. So you want to sell half your Exxon stock and invest the proceeds in another instrument.
From your research, you find two possible investment options.
Option one is shares of Chevron, another multinational oil and gas company. Option two is the Fine Art Fund; a mutual fund made up of fine art investments. Both have the same expected returns, 25%, and standard deviations, 20%.
If they both have the same risk-return profile, does it really matter which one you select?
Yes!
In many ways, Exxon and Chevron are the same company. They are in the same industries, operate in similar countries, and are affected by the changing price of oil and related commodities. One should expect their share prices to mirror each other to a great degree.
Their performance will not be exact due to company specific risks.
In 1989, faulty equipment, human error, and fatigued crew were factors in the crash of the Exxon Valdez in Alaska. A crash that caused many problems for Exxon.
In Ecuador (and other jurisdictions), Chevron is involved with the Ecuadorean government (and others) over environmental issues that may result in fines and costs to Chevron.
But for the most part though, in the absence of unique situations, the share prices of major oil companies generally move together up or down.
That is why I would anticipate the correlation between Exxon and Chevron being close to 1.0 (i.e. 100% positive). Not exactly 1.0, as the two companies operate in some different markets, have different product mixes, different management, etc.
I would expect over a long period for the two companies to track each other quite well in share price. Compare the five year performance between Exxon (stock symbol: XOM) and Chevron (stock symbol: CVX) – you can compare companies using Yahoo Finance Interactive Charts – and the similarities over time are striking.
But although they are close, they are not exact matches. That is good for diversification.
But not great.
The Importance of Correlations
Anytime the correlation between two assets is less than 1.0, there is an advantage in reducing overall risk by adding the new investment to one’s portfolio.
That is because of the portfolio risk-return calculations.
In (very) short, by adding assets that are not perfectly correlated to each other, one receives the cumulative impact of the expected returns, but only a reduced impact on portfolio risk.
I have re-read the Investopedia definition of diversification a few times.
I do not really understand what they mean when they state diversification will “yield higher returns and pose a lower risk than any individual investment found within the portfolio.”
I agree with the latter part of the statement, but have trouble with the first section.
Correlations and Portfolio Expected Return
While diversification allows you to invest in assets with high expected returns, diversification does not give the portfolio any magic bump.
In an investment portfolio, the expected return of the portfolio is simply the sum of each individual investments’ weighted averages in the portfolio.
For a simple, two asset portfolio:
ERp = (Wa)(ERa) + (Wb)(ERb)
Where:
ERp = Expected return of the portfolio
Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)
ERa = Expected return of investment “A” in the portfolio
In our example, the expected return of Exxon is 15% and 25% for Chevron. If you invest 50% of your portfolio in each asset, the portfolio’s expected return should be 20%.
ERp = .50(15) + .50(25) = 20%
Pretty easy.
Remember that expected returns are just weighted averages of all the individual investments.
Correlations between assets do not impact the expected returns of the portfolio.
Correlations and Portfolio Risk
However, it is not that simple a calculation for the risk of the portfolio.
You need to factor the assets’ correlations into the equation. In a two asset (A and B) portfolio:
℺²p = (W²a)(℺²a) + (W²b)(℺²b) + (2)(Wa)(Wb)(℺a)(℺b)(pab)
Where:
℺ = Standard deviation
Wa = Weight in percentage of investment “A” in total portfolio (“b” for investment “B”)
pab = Correlation between investments “A” and “B”
The first part of the equation looks a lot like the expected return calculation. In that sense, there is a weighted average effect from risk.
But let us see how the second part of the equation alters the equation’s impact.
Diversification Impact of Strongly Correlated Assets
In our example, the standard deviation for Exxon was 10% and for Chevron 20%. Because the two companies are quite similar, I shall say that the correlation coefficient is 0.85. Not quite 1.0, but close.
If we crunch the numbers we see that the portfolio standard deviation is 14.49%. Slightly less than if we simply took the weighted average (15%) as we did with expected return.
The difference is due to the fact that the two assets are not perfectly correlated. However, because the correlation of 0.85 is very high, the reduction in risk is relatively small.
Diversification Impact of Weakly Correlated Assets
Now let’s consider our other potential investment; the Fine Art Fund. It had the same expected return (25%) and risk (20%) as Chevron. Therefore, we would expect an Exxon-Fine Art portfolio to yield the same expected return and risk as the Exxon-Chevron combination.
Actually, no we would not expect that in the slightest.
Here’s why.
In the real world, the correlation between fine art and oil companies is negligible. There is almost no correlation between the performance of Exxon and a bunch of paintings. Let us say the correlation between Exxon and the fund is 0.002.
Now for the numbers.
The expected return of a portfolio consisting of 50% Exxon and 50% Fine Art Fund would be 20%. The same as with the combined Exxon-Chevron portfolio.
This is because both Chevron and the Fine Art Fund have the same expected returns. And, as we saw above, expected return calculations are simply weighted averages of the portfolio’s individual investments.
But the portfolio risk is a different story.
If we crunch the numbers we see that the portfolio will have a risk of only 11.2%. Much less than a pure weighted average of 15% and significantly less than the Exxon-Chevron combination of 14.49%.
Yet the expected returns of both a portfolio of Exxon-Chevron or Exxon-Fine Art Fund are identical at 20%.
From a risk-return aspect, the Exxon-Fine Art Fund is the much better investment combination than Exxon-Chevron.
Why is Option Two Superior?
Because of the correlation between the assets.
Assets with high correlations receive some impact through diversification. But as you move toward a perfect correlation of 1.0, the risk reduction benefits from diversification lessen.
If you really want to reduce portfolio risk, you need to add assets that have low, or even negative, correlations to the assets already in the portfolio.
Investopedia states that diversification “mixes a wide variety of investments within a portfolio”.
True.
But to make it worthwhile, be certain you consider the correlations between assets as well as expected returns and risk levels in your investment selections. You want to add assets that are weakly correlated to your existing portfolio. Not simply a “wide variety of assets.”
The impact on your portfolio’s efficiency could be huge.
As for the optimal mix, there are many other variables that need consideration. We will look at them down the road in asset allocation and portfolio construction.
This sort of gets at the Investopedia claim about how diversification can “yield higher returns.” Say you find a weakly correlated asset that offers higher expected returns to add to your portfolio. You may be able to maintain your portfolio risk at its current level, yet get a bump by adding the potentially higher return asset. Poorly worded by Investopedia.
Next up, a few more thoughts on the benefits of diversification.
by WWM | May 24, 2017 | Diversification
In An Introduction to Diversification, we began our review of the subject.
Learning even a little about asset correlations is crucial to better understand why diversification is important in an investment portfolio.
Asset correlation is a relatively advanced topic. For some, that means I will not get into it as much as you would like. For others, your eyes may quickly glaze over in boredom.
Either way, I hope you gain some insight about correlation and how it can help you improve your investment results.
What is Asset Correlation?
Correlation is a statistical measure (no escaping the world of stats!) of how one asset moves in relation to a second asset.
With investment assets, risk factors can significantly affect performance. We looked at many of these variables in our discussions of nonsystematic and systematic risks. Government policies, inflation, interest rates, hurricanes, company management are a few examples.
The closer in characteristics two assets are, the more they will be affected by the same risk factors. The more divergent the assets, the less impact individual risk factors will have on each at the same time.
Let us use coffee shops to illustrate this point.
Two Starbucks franchises located on the same city block in New York are almost identical in nature. Same clients, same products, same impact from changes in coffee prices, and so on. There may be some minor differences, but not many.
If the city suffers an economic downturn, each shop should suffer equally. If Starbucks is investigated for selling coffee laced with carcinogens, business at both will fall.
Now compare a Starbucks with an Italian espresso shop on the same block.
Many of the same risk factors will be identical because of their physical proximity and product offering. If the local economy falters, both businesses may have difficulties. But if Starbucks is sued for potentially killing customers, Starbucks will suffer whereas there will be no negative impact on the espresso bar.
What about comparing two Starbucks? One in Los Angeles, one in Zurich.
Again, there are similarities between the two, but also large differences. If an earthquake in Los Angeles destroys every Starbucks in the city, there will be no problems for the Zurich franchise. If the Swiss economy struggles and customers look for more cost effective coffee options, that has no direct effect on business for a Starbucks in California.
We could look at many more combinations, but you get the idea.
Correlations and Investing
Like Starbucks’ franchises, some investments share many of the same traits and risk factors. Others have little in common. Some even react in opposite directions to the same risks.
How an investment moves or performs relative to another asset is its correlation.
And this correlation is the reason you want to hold a “wide variety of investments” (per Investopedia) in your portfolio.
When two investments are positively correlated, their performance will move in the same direction. Like two Starbucks on the same street.
When two investments are negatively correlated, if one asset outperforms its expected results, the other will underperform. Perhaps like a pawn shop on the same city street as the Starbucks.
When the economy is great, it’s frappuccinos for everyone. People are making money and not needing to hock their assets. The pawn shop is a lonely place.
But when bad times hit and people become unemployed, there is less money available for a premium priced coffee. Starbucks struggles and may incur losses. Meanwhile, the cobwebs have been cleared off the pawn shop cash register and business is booming. At least until the economy recovers and the Starbucks’ baristas are back at work.
If the movements of two assets are exactly identical, they are 100% positively correlated. If they move in exact opposite directions, they are 100% negatively correlated. If they have no relationship at all, the correlation is 0%.
In investing, correlations range from 1.00 (100% positive) to -1.00 (100% negative).
Most assets are positively correlated to varying degrees. In part this due to increasing globalization and far reaching risk factors that impact most assets. These include inflation, interest rates, government policies, and employment rates.
While most assets are positively correlated, few are perfectly correlated. That is, few assets have correlations of 1.0.
Consider the two Starbucks on the same street. As close in likeness as can be. However, one manager may be better than the other, resulting in customers buying more accessories. Or perhaps the baristas are better in the second shop. They are friendlier, faster, and serve better quality drinks. So although both shops have the same offering, customers over time may increasingly frequent the shop with better service.
Even in a small example like this, there are potential differences between almost identical businesses. This is equally true for investments. And, as we shall see below, these minor differences can play an important role in managing portfolio risk.
Correlations between two specific assets may change over time. As the characteristics and circumstances of the underlying investments shift, so too can the correlations.
Next up, a real life investment example of asset correlations in action.
by WWM | May 17, 2017 | Diversification
The key risk management tool for the average investor is portfolio diversification.
It seems like an easy concept, but it is a little more complex than it first appears.
Diversification and Investment Risk
Before we start our discussion on diversification, I want to point out a difference in my personal views and what is generally accepted in readings elsewhere.
In learning the distinctions between nonsystematic and systematic risk, diversification is normally number one on the list. That is why nonsystematic risk is also known as diversifiable risk and systematic risk is also termed non-diversifiable risk.
You will usually be taught that nonsystematic risk can be minimized through diversification. However, systematic risks cannot be diversified away.
If you are writing a finance exam, I suggest that you bear this in mind.
I think this is incorrect, but I do not want to be the one helping you to fail an exam.
As we go through diversification, I will provide examples of how to reduce systematic risks in one’s portfolio. You can decide if, in the world of non-academia, I am correct or not.
What is Diversification?
Investopedia defines diversification as:
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Okay.
This definition makes some sense if you already know what diversification is. But if you are unfamiliar with the concept, I think it makes little sense.
And it is somewhat misleading to a non-professional investor.
For those that want to understand this very important concept, we shall attempt to dig deeper into diversification.
Digging Deeper into Diversification
Diversifying a portfolio does require one to hold a “wide variety of investments”.
But it is not that simple. We shall consider the following questions:
Why must a portfolio contain a “wide variety of investments”?
What constitutes a “wide variety”? 5 assets? 50? 500?
Are any “mixes” of assets acceptable?
Will a diversified portfolio actually generate “higher returns and pose a lower risk than any individual investment found within the portfolio”?
The answers to some of these questions may be found in a look at asset correlations.
So correlations will be our initial foray into the world of diversification.
by WWM | May 10, 2017 | Risk
Becoming an effective investor requires you to properly manage investment risk.
Today we shall look at how this is typically done.
Previously, we reviewed ways to manage pure risks in daily life. These included: risk retention, risk avoidance, risk transfers (including insurance), and loss control.
Some of these tools may also be used to address investment risks. While risk retention may be used, it makes little sense to review in an investment context, so we shall skip any discussion of it.
Risk Avoidance
In some circumstances, you can use risk avoidance to eliminate or minimize the potential impact of certain systematic and nonsystematic risks.
A hurricane is a systematic risk. While you cannot avoid the impact on companies affected by the hurricane, you could avoid investing in companies that operate in hurricane belts, such as the Caribbean or Gulf Coast.
The same applies for political risk. If you have concerns a country may nationalize assets of foreign companies, excluding investments in companies that operate in that country would eliminate this risk. General Motors is a good example.
Management risk is a nonsystematic risk. If you worry about the next Kenneth Lay managing one of your investments, you can avoid buying shares in public companies. Instead, you could invest in money market funds or term deposits to eliminate management risk. Of course, you still need to worry about the fund company and bank.
Investors with extremely low risk tolerance may use this technique to avoid many risks. Unfortunately their investment options are limited and their returns will be low.
Additionally, there are certain risks that cannot be avoided.
If you invest in US government Treasury Bills, you do not (as of this date) have to worry about management or credit risk. However, the risk of inflation can impair or even destroy your invested capital. A decrease in interest rates may create reinvestment risk. Or, a weakness in the US dollar may result in currency risk. And so on.
With each potential investment there are specific risks you can avoid. But also other risks that cannot be avoided.
And each investment will have a different combination of avoidable and unavoidable risks.
Not good, is it?
Well, as we shall see later, this actually has its advantages for investors.
Risk Transfers
Financial markets do a good job of allowing investors to effectively transfer risk to others.
Hedging can reduce risk by transferring risk to other investors or speculators. In fact, that is a key function of speculators. They accept risk from those who wish to hedge their activities.
There are different methods to hedge ones risk exposure in investing.
In addition to pure hedging actions, the use of swaps, derivatives, and other more complex financial transactions can be used to alter the risk-return profile of investments.
An example of a risk transfer is a capital protected mutual fund. This type of fund invests in different investments (e.g. S&P 500 fund, bond fund), yet the fund guarantees your invested capital from loss. Some funds guarantee 100% of your capital, others 90% or less.
The attraction is that you are able to participate in the upside return potential of the underlying investment. Yet you are protected from any downside risk of monetary loss. Note that this would be an example of an asymmetric return profile that we looked at in our limitations of standard deviation discussion.
Pretty good. Risk of outperformance, but no risk of loss.
Of course, there is a cost associated with transferring the downside risk elsewhere. The greater the percentage of capital that is guaranteed, the greater the cost. Depending on the investor, that cost may make these investments unattractive.
There are a variety of ways to create a fund such as this one. Combining a Treasury Bill and a call option is one simple method. However, these are advanced techniques that are outside the scope of our discussion.
We will look at risk transfers, in brief, at a later date.
Loss Control
Loss control involves identifying all risk factors present and attempting to minimize or eliminate the key risks. For key risks that cannot be minimized, one tries to reduce the potential loss should it arise.
The first step is, in part, dealt with above in risk avoidance.
The second step involves prudent investment practices.
Prudent Investment Practices
One important measure is in understanding how to invest.
Hopefully this investment series and ongoing commentary will provide some pointers.
One can also take courses that provide the basics for investing. Many on-line brokerage firms and banks provide internet tutorials and webinars as well. There are many options for improving one’s knowledge on how to invest.
A second measure is to undertake proper research before investing one’s capital.
We will look at investment analysis in detail later this summer. It is not that easy a task. I think it requires some expertise in finance and accounting to properly analyze traditional investments.
For non-traditional investments such as art, collectibles, and even real estate, you also require strong knowledge about the asset itself.
Since I was young, I collected coins. I have some knowledge of them as an asset class and investment. But I know nothing about stamps, so I would never invest directly in stamps.
In fact, I would be leery of seriously investing in coins as well. While I have some knowledge, I could not successfully compete against experts in the field.
I would never play golf against Rory McIlroy for money. Similarly, I would never compete against experts in any other area unless I was equally proficient. If you do, you are playing a fool’s game.
That said, if you learn how to research investments, you can glean valuable information concerning potential risks.
Perhaps you worry about legal or credit risk. You can get clues about the likelihood of these risks arising through analysis. Financial statements, corporate releases, and news items will provide information concerning past, ongoing, or potential litigation. I always find that the best information is buried deep within the notes to the financial statements.
A review of the business can also provide hints for potential problems.
For example, mining and offshore oil companies run a risk of accidents and environmental damage that may result in litigation. Look at Massey Energy or British Petroleum in 2010. Contrast them with Apple. Yes, there may be other legal issues for Apple, but Apple investors need not worry about mine collapses or oil spills causing losses on their shares.
Financial analysts’ reviews and recommendations can also help you find investments that may perform better than average. Not necessarily so, but a good place to begin your own analysis.
A third measure in controlling risk is through your portfolio construction.
The keys here are diversification and asset allocation.
I think that asset allocation is diversification, but most people separate the two, so I shall follow suit.
Diversification and asset allocation are extremely important for investment success.
We will save asset allocation for when we discuss portfolio construction.
But next up, we shall take a detailed look at diversification.
by WWM | May 4, 2017 | Risk
Managing risk is extremely important in daily life, as well as in business and investing.
Today we look at five key ways to manage pure risks. These include: risk avoidance, loss control, risk retention, non-insurance risk transfers, and insurance.
While the terminology may be new, you utilize some or all of these techniques on a daily basis. So this is just a refresher.
Risk Avoidance
By avoiding a specific risk, you attempt to eliminate it entirely.
Certain risks are relatively easy to avoid. You can completely avoid the risk of divorce by never getting married. Or you can eliminate the risk of a shark attack by never going into an ocean (and watching out for Sharknados).
Some risks, like death, cannot be avoided, no matter what actions are taken.
In between these two extremes lie the majority of risks that impact life on a daily basis. These risks can only be avoided provided you are willing to sacrifice much of your existence.
For example, you can eliminate the risk of an automobile accident by not owning a vehicle or ever riding in one. Or you can avoid being mugged on the street by never leaving your home.
For most people, this is not a practical, nor enjoyable, way to manage risk.
Loss Control
Loss control works in two ways.
First, loss prevention is used to to assess the probability of risk. The specific factors that make up a risk are identified. Then actions are taken to eliminate or minimize the key factors.
Second, for those risk factors that cannot be eliminated or minimized, steps are taken to reduce the loss that will be experienced should the risk occur.
Consider the factors involved in an automobile accident. They include: driver skill, driver issues (e.g. intoxication, tiredness, poor eyesight), vehicle road-worthiness, road conditions, volume of traffic, the actions of other motorists, etc.
Some loss prevention measures may avoid certain of these factors.
By ensuring that your vehicle is always in excellent condition, you substantially reduce the risk of mechanical problems. If your signal lights are operational, you minimize the risk that other drivers cannot determine your intentions. By only driving while sober, you eliminate the risks involved with driving while impaired.
Other risk factors can be somewhat reduced but not eliminated.
You could take a driver training course to improve your skills and confidence. When driving in winter conditions, you can ensure that you are using snow tires to assist with the icy roads. You can drive primarily at times when the roads are less congested and not during rush hour.
While these actions help reduce the probability of having an auto accident, they do not entirely eliminate the possibility. This is where loss reduction comes into play.
Realizing that a loss may arise regardless of one’s (reasonable) actions, you can try to minimize the physical, emotional, and monetary damage done.
Driving at a speed appropriate for the conditions is one example. It reduces the odds of an accident (loss prevention), plus it may reduce the actual loss if there is an accident. The financial cost of an accident and the personal injury should be less at lower speeds.
A seatbelt is another way to reduce loss. If you get into an accident, it is usually safer for those wearing a seatbelt.
Avoidance and Loss Control are active measures to eliminate or minimize risk.
There are three financial ways to also manage risk: risk retention; non-insurance risk transfers; insurance.
Risk Retention
Risk retention is the managing of risk internally. It is accepted that there is a risk involved in all activities. The company or individual assumes responsibility, in whole or in part, for the potential damage that may occur from the risk.
Risk retention occurs because alternative risk management tools are not available or they are prohibitively expensive.
For companies that retain many of their own risks, this is called being self-insured.
Because of the high cost and uniqueness of many corporate risks, more and more businesses self-insure.
Individuals also engage in risk retention. In fact, everyone reading this post is retaining some risk at this very moment.
Automobile insurance is a good example of risk retention in everyday use. Within the contract, there is usually a deductible (or “excess” in some countries). If it is $300, then you pay for the first $300 on any claim before the insurer covers the remainder. In effect, you have retained the risk for any damage up to $300.
Deductibles are common in medical, dental, and travel insurance as well for individuals.
The other thing to notice with an insurance deductible is that the amount will affect your premiums. If you assume a greater percentage of risk by moving your deductible to $600, your ongoing premiums should decrease. Conversely, if you reduce your deductible to $50, you will see an increase in your premiums.
The greater the risk you retain, the less you should pay to transfer the remaining risk to another party. That holds true for standard insurance, but also in respect of investment risk. As we will see over the next while.
Non-insurance Risk Transfers
These transfers typically involve either contracts, hedging activities, or incorporation.
Contractual Risk Transfers
Through a contract, risk may be transferred from one party to another.
For example, you buy a new MacBook from Apple. The computer comes with a one year limited warranty as part of the purchase price. Hopefully the life of an Apple computer exceeds one year, especially at the prices Apple charges. So what happens if your computer crashes in the thirteenth month? Or thirty-third? After twelve months, the risk is all yours.
However, AppleCare offers the ability to extend the initial warranty for an additional two year period. This contractually shifts the risk of loss through certain damages to Apple for the agreed upon period.
When contractually transferring risk, be sure to know exactly what is in the contract.
A “limited warranty” is so named because it is limited in scope. While you transfer some of the risk to another party, chances are there are key risks that you retain.
AppleCare’s limited warranty does not cover “damage caused by accident, abuse, misuse, liquid contact, fire, earthquake, or other external causes”. Abuse and misuse are nebulous terms that make filing successful claims more difficult.
As an aside, there is a great example within the Apple exclusions. The last Applecare terms and conditions I reviewed stated “flood” and not “liquid contact”. Exclusions within insurance contracts seldom improve over time for customers.
This is another general rule to always remember. The party that writes the contract usually gets the best of the terms. If signing on to a standard contract that you cannot amend, you will normally be at a disadvantage when problems arise.
Determine the “exclusions” in any contract before deciding to purchase it. The risks you actually transfer may not be worth the cost. In the case of a MacBook, sure you may get a lemon. But you will notice within the original 12 month warranty period. You are much more likely to drop your MacBook, spill coffee on it, or have your cat scratch the screen. Actions that are not covered in the extended plan.
You must decide if the probability of something happening that is covered is worth USD 349.00 for two additional years. Ensure you know exactly what is covered and what is not. Then decide if it is worth the additional cost. Often it is not.
Hedging
Hedging activities may also serve to reduce risk. It is especially useful when addressing portfolio risk.
We will consider hedging in much detail at a later date.
Incorporation
Finally, a corporation or limited liability company may be used to reduce personal risk.
For example, you run both a landscaping business and a home building business as separate sole proprietorships (i.e., unincorporated). Landscaping has become a very lucrative business and you earn $100,000 annually from it. Unfortunately, your goal of building window-less houses has not fared as well. In fact, your creditors are taking you to court for unpaid bills.
Since both businesses are sole proprietorships, creditors will be able to attack you personally to get their money. Although your landscaping business is entirely separate, the home building creditors will take those profits.
However, if both businesses had been incorporated, with some important exceptions, the creditors of the home building business may be unable to take money from the landscaping company.
Note that this is a simple example. As more individuals incorporate to limit their personal liability, there are additional options for “piercing the corporate veil” and attacking the actual owner for his actions.
Insurance
We saved the obvious and most widely used risk management tool for last.
Insurance is used by individuals, businesses, and other organizations to offset many risks.
Premiums are paid to an insurance company. In exchange, the insurer assumes the pure risk and agrees to pay a certain amount should a loss arise.
Like any contract, be certain to know the “exclusions” in any insurance coverage. Often people are surprised by what is not included.
We will look at insurance in greater detail later in the series. As I am certain that almost everyone has dealt with insurance companies on some level, our focus will be more on life related insurance topics.
Which Tools Should You Use?
Whether in your personal life, business, or investing activities, you will use each of these tools in some combination.
What is the best combination for one person, may not be right for another.
As we discussed with risk in general, each individual’s risk tolerance may differ.
Extremely risk averse individuals may want low deductibles to cover every problem. They purchase extended warranties on products. In exchange for greater peace of mind, they willingly pay a premium for additional protection.
Those who are extremely risk tolerant will never buy extended warranties and carry high deductibles. In business, they will self-insure. They believe money saved on insurance premiums over time will more than offset any future losses.
How you combine these tools is completely at your discretion.
How have you already used these tools in your life?
Your views and actions will help you to understand your own personal level of risk tolerance.
It is important for investors to learn about themselves. How one invests is usually a function of one’s risk tolerance.
We will look at investor risk profiles in the near future.