By Dr. Jim Dahle, WCI FounderThere are a lot of financial risks in your life. I frequently run into people who are worried about the wrong ones, though. They seem to have little insight into what their biggest risks are. Our biggest financial risk frequently changes as we move throughout life, and it is important to recognize and protect yourself against your biggest risks. Here are some of the financial risks that you might run into at some point during your life:
- Market risk
- Interest rate risk
- Inflation risk
- Risk of running out of money due to inadequate returns
- Risk of disability
- Risk of death
- Leverage risk
- Small business/entrepreneur risk
Now, let's go through a few scenarios. We'll first list the financial risks that each person is running, and then identify the largest risks and how to protect against them.
Scenario #1: A Recent Retiree
Jill recently became financially independent, and she retired. She is 68 years old and single, and she has her home paid off. She has a $1.5 million portfolio invested entirely in stocks with a sizeable small value tilt, receives $25,000 per year from Social Security, and spends $85,000 per year. Which of these financial risks is she running?
- Market risk
Interest rate riskInflation riskRisk of running out of money due to inadequate returnsRisk of disabilityRisk of deathLeverage riskSmall business/entrepreneur risk
Market Risk
In this carefully crafted scenario, she is quite protected from most of these risks. Given her aggressive portfolio, her returns are likely to be adequate to keep up with inflation and provide enough of a return to support a 4% withdrawal rate. She faces serious market risk, however. In a bear market, she could lose 50% or more of her portfolio. That would introduce sequence of returns risk, and it could possibly even cause her to panic and sell low, a real tragedy.
Protection Measures
She could protect herself from this risk by dialing back the portfolio risk a bit. She could have a less severe factor tilt, add some bonds or cash to the portfolio, and maybe even diversify a bit into real estate to protect against an isolated stock downturn and improve income. Yes, this will somewhat increase her inflation risk and risk of running out of money, but a more balanced approach between her risks is likely indicated.
More information here:
Scenario #2: The Scaredy Cat Retirees
Jose and Isabella also recently retired. They are 63 years old and are already collecting both of their Social Security checks for a total of $35,000 per year. They have no debt. They spend $90,000 per year and have a $1 million portfolio invested in a combination of nominal bond funds and CDs. Which financial risks are they running?
Market riskInterest rate risk- Inflation risk
- Risk of running out of money due to inadequate returns
Risk of disabilityRisk of deathLeverage riskSmall business/entrepreneur risk
Inflation Risk/Running Out of Money
This couple has serious exposure to inflation risk. Just a few years of double-digit inflation would seriously erode their asset base. Their only protection against inflation is the Social Security adjustment they would see each year. Perhaps more significantly, they have a portfolio with a nominal yield of something like 2%-3%, but they are withdrawing $90,000-$35,000 = $65,000/$1 million = 6.5% per year. Even if inflation were 0%, which it almost surely will not be, they will drain their entire portfolio at some point in their 80s and be living on just Social Security.
Protection Measures
The most reliable protection is to simply spend less money. This will dramatically reduce the risk of running out of it. In addition, if they were to run even a little bit of market risk (perhaps increasing the portion of the portfolio dedicated to risky assets, such as stocks and real estate, to 25%-50%), they would further reduce that risk and protect themselves against inflation. Here are some other potential measures:
- Swapping out some of the nominal bonds/CDs for TIPS would also provide some inflation protection. There are other alternatives, too.
- They could purchase a Single Premium Immediate Annuity (SPIA) to protect against running out of money, although it wouldn't do much for inflation risk.
- They could use some of their home equity to support their lifestyle. They could do this most simply (but not necessarily most easily) by downsizing and investing the recaptured home equity.
- They could also run some leverage risk by taking out a mortgage or HELOC and investing the freed-up assets in hopes of earning a higher rate than the mortgage.
- A reverse mortgage may also be an option, although it comes with serious downsides and additional risks (at least to any potential heirs!).
Scenario #3: The Young Dentist
Lavar is a young dentist, fresh out of school, with three kids and a stay-at-home wife. He has a $500,000 student loan burden (refinanced to a variable 5.4% on a 15-year term), a $500,000 mortgage (fixed at 4.5%), and a $500,000 practice loan (variable 10-year loan at 5%). He made $150,000 last year and hopes to break $200,000 this year. He has not purchased any disability or life insurance because they are struggling to support their lifestyle while covering all of the debt payments. There is no portfolio yet either, but his employees are bugging him about putting in a retirement plan at the practice. What financial risks is he running?
Market risk- Interest rate risk
Inflation riskRisk of running out of money due to inadequate returns- Risk of disability
- Risk of death
- Leverage risk
- Small business/entrepreneur risk
Risk of Disability
Lavar is running a ton of risk in his life. The biggest risks for him and his family, however, are his death and disability. His ability to earn a living is his greatest asset, and it is completely unprotected. Luckily, if he is healthy, this problem is easily solved with some simple disability and life insurance. Yes, that is going to cost him some money, but frankly, he can't afford not to have this insurance at this time in his life. Even if it means putting off investing or a debt payoff, these insurances are absolutely critical for him and his family.
Leverage Risk
He is also running a pretty massive leverage risk. He owes 10X his income. To make matters worse, 2/3 of this debt is exposed to interest rate risk. While I am often an advocate of running interest rate risk yourself when you can afford to do so (i.e., refinancing student loans to a five-year variable rate when you're planning to pay them off in two or three years), it does not appear that Lavar can afford to do so. In addition to all of this, Lavar is struggling to get this practice going. He lies awake at night wondering if he is going to make payroll each month. He has serious small business risk as well.
Protection Measures
Perhaps the best solution for Lavar and his family at this time is to get very hardcore about personal finance. He needs to boost income, cut spending, and get himself some breathing room. Any spending he does should be business spending directly aimed at increasing income through marketing or developing new skills, products, and services. Perhaps salaries at the practice can be cut in the short term by changing contracts to increase profit-sharing or even equity in hopes of improving cash flow now.
The debts can be restructured (and made fixed or even longer-term), but if he can double or triple his income, they all become much more manageable. If his practice is nowhere near full, perhaps he can even do some moonlighting as an associate for a while to increase income.
More information here:
How to Think About Risk and Why It’s So Hard to Quantify
Risk vs. Reward — How to Find the Balance
Scenario #4: The Physician Real Estate Guy
Patrick is a single hospital employee nephrologist ($240,000 income), a few years out of residency who really got into real estate investing recently. He has no disability insurance. He has refinanced his $250,000 in student loans to 3.5% fixed, but he doesn't want to pay them off any faster than he must so he can invest more. He has about $50,000 in a 401(k). He recently moved into a duplex he bought, and he is renting out the other side. In the last year, he has closed on two other properties. One of these properties he used to live in and bought with a physician mortgage with 5% down. The mortgage is less than the rent, but for some reason, something seems to come up every month. Therefore, he is cash flow negative on the property. The other property is a fixer-upper that he hopes to get a renter into soon. What financial risks is Patrick running?
- Market risk
Interest rate riskInflation riskRisk of running out of money due to inadequate returns- Risk of disability
Risk of death- Leverage risk
Small business/entrepreneur risk
Patrick has three main financial risks to be concerned about.
Market Risk
He has some market risk as the real estate market could turn on him. Property values could plummet, and rents could even drop. Maybe he can't find a good tenant for the fixer-upper. He worries a lot about that risk, but in reality, his other two risks are far larger.
Risk of Disability
He should get disability insurance ASAP, as his ability to work clinically is still his greatest asset and is holding the whole house of cards together.
Leverage Risk
He is also massively overleveraged. He owes hundreds of thousands of dollars. He doesn't have a single cash-flow positive property helping him pay the bills. Getting on top of his cash flow situation and debt-to-income ratio needs to be a big priority.
Protection Measures
When you find yourself in a big hole, Step 1 is to stop digging. He needs to stop buying properties with money he doesn't have to impress people he doesn't even like. He needs to take a deep breath and slow down this real estate train. It isn't that real estate is a bad investment. It isn't even that these are bad properties. But the method and timing of his purchases are putting his whole financial life at risk. When real estate investors go broke, it is usually like this. Add a couple more cash flow negative properties into the mix or have even a minor hiccup in the real estate markets, and it all collapses.
Perhaps one solution is to get this fixer-upper done and flip it. Maybe he makes some money, but if nothing else, he reduces his debt-to-income ratio. He might also want to sell his old home if he isn't too far underwater on it. He simply needs a stronger base with which to build his empire. Putting 25%-35% down on these properties likely turns them into assets putting money into his pockets every month instead of liabilities that are taking money out.
A minor point, but his real-estate-to-stock ratio is awfully high, and he may be missing out on a lot of the tax benefits of using retirement accounts, too. Perhaps starting a Backdoor Roth IRA and investing it into index funds each year in addition to maxing out the 401(k) could help balance that. Getting those student loans out of the way would also improve his cash flow.
Scenario #5: The Multi-Millionaire Entrepreneur
Wanda has done very well for herself. She has never been a fan of debt, so she paid off her student loans quickly after school and bought appropriate amounts of life and disability insurance. She even paid off her house in just seven years. She has ramped up the spending quite a bit, but she still saves about 20% of her gross income per year and has a million dollars spread across a portfolio of stock and bond index funds—both inside and outside retirement accounts. She also has a couple hundred thousand dollars in real estate syndications that have done pretty well.
She started a side business a few years ago, and it really took off. She cut back on her clinical work, and her husband has quit his job and is now staying home with their two kids and helping out in the business where he can. She recently got a $3 million buy-out offer for the side business, and she is having trouble deciding what to do. What financial risks is she running?
- Market risk
Interest rate risk- Inflation risk
Risk of running out of money due to inadequate returnsRisk of disabilityRisk of deathLeverage risk- Small business/entrepreneur risk
Entrepreneurial Risk
Yes, she has some market risk and probably even a little inflation risk. But it sounds like those are under control and well-managed risks. The real risk here is entrepreneur risk. Maybe the buyout offer is contingent on her sticking around for three or four more years in the business. She doesn't really want to sell as she enjoys it, but 2/3 of their net worth is now tied up in a single business in a risky industry. At this point, a big part of their income and financial lives is tied to the business. She might have trouble going back to full-time practice, and her husband burned a few bridges when he left his job.
Protection Measures
What can they do to mitigate their entrepreneurial risk? There are a few options:
- Pull profits out of the business (rather than reinvesting them) as quickly as possible and invest them in stocks, bonds, and real estate. Once they are financially independent (FI) just from their investments, they'll still be FI even if the business completely collapses.
- Sell the business and take all that money off the table. This would make them FI, although it would crush their dreams of making the business even bigger. Plus, it would not be nearly as much fun without the control they have enjoyed.
- Sell part of the business by bringing on some investors. Some of that money could be used to “take money off the table,” while another chunk of it could be reinvested into the business.
- Buy some “key person” insurance in addition to her personal life insurance to further protect the business.
- Borrow against some of the assets in the business and invest that money into the stock, bond, and real estate portfolio.
- Restructure the business a bit to provide some asset protection for it from her clinical practice.
- Hire out some jobs in the business to allow her to pick up more clinical hours and diversify their income.
Luckily for Wanda, this is a great position to be in, but that doesn't mean she can't minimize her biggest risk by some combination of the above.
What do you think? What are your biggest financial risks right now? What are you doing to protect yourself from them?
[This updated post was originally published in 2020.]
Great article.
Quick question – where is the inflation risk in the last scenario?
She has $3M sitting in cash. If inflation takes off, it could drop significantly in value.
It’s so important to continually evaluate what your biggest risks are and protect against them. They will be constantly evolving as your individual financial situation changes. Such great advice!
Right now, my biggest risk would be loss of income. That income is what largely supports the “needs” in our budget but also supplies our 41% savings rate to aggressively pay off loans and invest towards FI. Strong disability and life insurances protect us against this risk and are well worth the marginal relative cost!
The Prudent Plastic Surgeon
WCI, as you know, the risks in retirement are much different than the risks during accumulation. I would favor separate discussions of each.
For instance in retirement, Longevity risk is the greatest risk and is a risk multiplier– it makes all the risks greater. You mentioned Sequence of Return Risk, which is easily managed if you have more than enough to retire. Then there is healthcare/LTCI/frailty risk which is also huge. Finally don’t forget tax/legislative risk to which retirees are more vulnerable and the widow/widower tax penalty.
Thanks for the discussion.
Good points.
I hate the name “longevity risk.” May we all be able to live a long, full life. The risk is really “running out of money” risk, not just living a long time.
Even though divorce is less common in physician households it does happen. It’s one of the quickest ways to lose 50-60% of your net worth in one fell swoop. It is important to take steps in protecting your marriage (date nights, financial discussions etc to try and get on the same page).
I like the breakdown of scenarios showing how variable risk is depending on your situation.
I was really surprised that WCI didn’t list divorce on its own or in some category like a modified #5 or 6. As you usually say divorce is about the most likely risk for those of us otherwise on the right track, and in addition to our own disability the less likely but all too frequent devastation of spouse or child ending up needing a lot more resources than expected – disabling injury or illness or congenital issue – and needing one or both spouses to work/ earn less to provide care or more/ longer to pay for unexpected care needs. And perhaps needing a plan extending for a child’s lifetime rather than just the parents/ spouses.
Excellent point.
Same here about Divorce and professional burnout. Would anyone care to comment on how to put a value on working a bit less and perhaps a slightly longer road to FI if that extra time meant enjoying your career and having a healthier marriage? I’m not saying you can’t have it both ways.
Yes, it makes lots of sense to crush burnout and prioritize relationships over money. Balance and moderation in all things.
To quote the late great Charlie Munger, 3 ways to go broke at liquor, ladies, and leverage
Agree with FiPhysician above. SORR is negated by having a larger portfolio than you need and a cash position. I am handling longevity risk by waiting until 70 for SS. I might even buy a SPIA at 70. I manage frailty risk by doing things like yoga and weight lifting. You have to take on some risk to be in a position to retire but you need to understand them. Good article.
Agree with FiPhysician and Hatton/1. Longevity is a risk multiplier.
Physical frailty can be mitigated with yoga, weight lifting, swimming, etc.
Also, with age, there can be a decline in mental acuity and impaired financial decision making.
So, using a SPIA not only helps address longevity risk, a lifetime income from a SPIA purchased at age 70 or 75 is easier to “manage” than say applying the 4% “rule” to one’s small cap growth portfolio at age 92 when it dropped 30% in value.
A SPIA helps with longevity risk, but increases inflation risk since you really can’t get inflation-adjusted SPIAs any more.
Great article….great read…..applicable to all. Thank you.
Surprised that Wanda isn’t already FI. Since her business has already taken off, taking profits is justified; this is something that could be changed either direction as needed.
I’ll talk to her about it. 🙂
Just wanted to remind you that posts like these really do make a huge difference in the lives of your readers! Wonderful examples, straightforward, and lots to think about.
Thanks for your kind words.
Math is a bit off for scenario 2: “but are withdrawing $90K-$35K = $65K/$1M = 6.5% per year.”
Good catch. Thanks.
Very nicely done Jim!
Speaking on disability risk: I was asked to discuss some personal finance topics on disability insurance to our CA-3’s recently. I asked how many of them have obtained disability insurance. Not one person had obtained it. I was floored!
Morgan housel stated it best: “Risk is what you don’t see”
Thanks,
Psy-FI MD
This was a fun read! I enjoyed guessing before checking the risks and seeing if I was right and I learned about some risks that I personally need to consider mitigating. I’m a long time reader and podcast listener and I thought Wanda sounded a lot like you…
Certainly some similarities.
Regarding RE Investor Scenario #4
Build a strong foundation. Don’t just do a deal to do a deal. Appreciation in most areas is becoming less and less likely so in my mind there are reasons to purchase a negative cash flowing property are few and far between.
Put 25% down and run numbers to be certain it will cash flow and that’s it – that’s the main ingredients for a successful RE recipe.
Flipping while being a full (or nearly full time) doc seems like an unnecessary headache. I’d rather work an extra shift a month then put that money in a cash flowing property!
Lastly – the list is a nice reminder of risks, but perhaps the greatest risk is as Twain said
Its not what we know that gets us in trouble…its what we know for sure that just ain’t so.
Who had pandemic and 50m jobless on their radar?
I rent to healthcare workers (80% of tenants)
Sometimes we get a little lucky!
Happy hunting
Justsayin
I agree with your formula. It’s pretty rare to have a cash flow positive property without 20-33% down.
I see the 25-30% down as equating to confidence in the deal.
If you are that confident you’ll commit the money to the deal.
5% might have worked a a decade ago until now, but boy that’s too much leverage.
I would add: tenant selection is super important – too many friends have property managers who are paid to fill the property, but with whom is the main question.
Put 25%+ down and be hyper-selective with tenants
I’m actually still buying now….building cash reserves and deploying as I find deals
Happy hunting
JustSayin
More down doesn’t mean more confidence. You’re on the hook either way for the entire value. It just lowers risk (and possibly returns).
The problem with selecting your own tenants is it isn’t scalable.
define scalable? How many units?
I will have 25+ in a couple months and will have 50 in a couple more years.
I choose residents and fellows so year to year turnover is low – they often hand off to another med student, resident or fellow..and nurses. Sure maybe not 200 units, but I have a recipe that will allow me to vet the tenants efficiently in short order
Find a niche and work the niche
But I get what you’re saying – my situation is unique
To the other point – perhaps another way of saying it – if you only have 5% down you shouldn’t be buying. Wish I could find cashflowing properties with only 5% down~
JustSaying
So let’s say you average turnover once every two years and have 200 units. That’s 100 new tenants a year. That’s two a week. And let’s say to be picky, you have to screen 8 for every one you take. So now you’re looking at 16 tenants a week. Is that really how you want to spend your life when you own 200 doors? Probably not.
It’s not scalable to pick your own tenants/manage your own apartments, especially if you want to practice medicine too.
Math…..good points turnover is more like 3+ years but agree that it’ll drop lower at scale. Building out a team so we’ll see. Target is 250 self owned by age 50. And I’m not talking 25k places in the South – these are ~100-125k per unit. I could raise money to do it faster, but I like the autonomy (for now). Another layer of issues if I add partners.
Now more than ever docs need multiple flows – I’m pressing hard to make it happen – still drive my subaru from residency a decade ago though I am in Martha’s Vineyard in a home I rented for the week – a balance I suspect like most.
Thanks as always for what you do –
JustSayin
White Coat Investor has conclusively shown that Personal finance is only slightly math based (and more related to behavior) given that even he has posted a page with a math error – See Scenario 2 – 90 – 35 is 55, not 65. Hence they would need a 5.5% return. Not quite as bad, but still likely unachievable with bonds & CDs.
I enjoyed the read. Thank you. In scenario 4, it currently reads 25-25%. Should that say, 25-35%?
Scenario #1 – Jill: How in the world does she spend $85K per year (in 2020)?! She owns her home, you didn’t say anything about car payments… did she buy a second home/condo? Do a home renovation? Is she spending all that on insurance? Extensive travel? I am in almost the exact same situation and I spend under $20K per year. $85K is a lot for one person. Well, if Jill stayed invested and didn’t ramp up her spending even more, she’s probably easily over $2M portfolio by now. Good luck, Jill!
You’re definitely in a small minority to be spending <$20K a year. Lots of families spend that much on one vacation.
Sure, but I was addressing only *one-person* “families,” as given in the example of Jill.
I’m still impressed with anyone who can live on $20K a year.
Own my home.
Cut my own lawn, clean my own gutters, etc.
Groceries from Aldi.
Thermostat set at 86.
Two cell phones, $15/mo and $5/mo.
Drive in the right-hand lane.
Clothes from thrift stores.
One streaming service (Hulu), $0.99/mo on Black Friday.
You get the idea.
Largest annual expenses are property tax, homeowner insurance and income tax.
Use Glenn Reeves’ current year tax planner to project income and keep taxes in 12% tax bracket. (https://sites.google.com/view/incometaxspreadsheet/home)
I will relax the frugality in another year or two. I realize it’s extreme.
What will be different in a year or two? Die With Zero might be a book worth a read for you.
Another risk is not spending enough money, and later in life regretting saying no to memorable experiences, charities, helping friends and family, buying back more of your time, etc.
Excellent blog. Long term care costs are another major risk. In case I missed it I didn’t see this in your outstanding blog unless disability risk is an indirect factor. I would love to see a major Blog with effective strategies in planning for self funding for long term care expenditures. (Excluding LTC insurance as an option) LTC expenditure is a MAJOR risk and is an unknown future challenge.. For example, your thoughts or guests on using traditional IRAs, Roth IRAs, taxable investments, real estate investments, selling the house, reverse mortgage, or cash holdings, Plus, how do the tax implications impact planning, such as medical expenses above 7.5 percent of adj gross income impact one’s planning strategy. In addition, do your readers or guests suggest setting aside a specific and separate amount in case LTC costs are needed. Or, perhaps they feel that if they are wise and prudent with investments they can then tap these investment sources if ever needed? Lastly. How much do your health care provider readers actually set aside, if any, for self funding LTC expenses?
A huge risk seldom discussed is that you underestimate your expenses in retirement. And the farther removed your current lifestyle is from the one you want in retirement, the more likely that you’ll mess up with this estimate.
In your scenario #1, a US investor wholly invested in small-cap value companies actually had a higher safe withdrawal rate than an investor with a traditional 60/40 portfolio (6% vs 4.1% since 1970). It’s remarkable yet true (www.portfoliocharts.com).