Wednesday, March 18, 2009

7 New Rules of Financial Security

Rule #1: Risk
Risk isn't about a gut feeling anymore. It's about making or missing important financial goals that you set out for yourself when creating a financial plan. People have begun to rely too heavily on stocks and that is the real risk in our situation. Stocks aren't a bad thing, however. You shouldn't run away from risky investments, and a buy when a stock price is down isn't the right call either. The answer lies in the following statement: How much risk you can take is a matter of how much you can lose and still meet your financial goals.

Rule #2: Cash
Relying more on cash can rescue you in an "asset emergency." It is necessary to set aside money to cover mortgage and food should you lose your job. You may earn only 2% on this, but the risk is one that you should not take. What you should do, is look at the next 1-3 years and add up big expenses (i.e. tuition, wedding, down payment on a house). Once that total is reached, that amount of money should be held in a cash account or a low-risk investment. It is wise to build up emergency funds first and see if there is any flexibility on your other big ticket expenses. Also, if all of your assets are in a 401(k), move some of it to a low-risk investment.

Rule #3: Human Capital
Time isn't everything. You must also consider earnings potential. It is important when looking at a financial portfolio to not just see stocks and bonds, but human capital, as well. The safer your human capital is, the more chances you can afford to take with your assets (i.e. your portfolio). As the value of your human capital declines, you'll need to secure more of your savings. Something that is important to take into account is the nature of your career; it may make your human capital more bond-like or more stock-like. However, it is generally a good idea to hold a fair amount of stocks when you are younger. Something everyone should do is assess their human capital and then think about how long they'll be working, the stability of their current job, and their ability to change jobs if need be.

Rule #4: Borrowing
Borrow cautiously because you also have to worry about the other person's debt too. When looking at the current economy, the moral here is to be conservative. Yes, there are many good reasons to borrow, such as mortgage and college education. But don't stretch yourself as much. If your employer has borrowed a lot in the past decade and now needs to conserve cash, lay offs are imminent. Also in this case, you can't turn to banks because they most likely borrowed too much and can't help you. This will, in turn, cause you to not be able to shore up your finances. The key is to be very conservative. Get into things you can afford.

Rule #5: Housing
Your home won't make you rich, but it is an important savings tool. Home prices couldn't keep rising the way they had been these past decades. There was always much talk about how the market would cool off or get back to normal. However, long-run data told a different story. When taking inflation into account, real appreciation was unimpressive. A reason for this was that technology constantly kept supply up with demand and sometimes even ahead of it. Even when real estate prices are rising, gains on it aren't that great. You must take into account maintenance costs, insurance and taxes, remodeling feeds, and closing and selling costs if you buy. It's important to have modest expectations for your house as a wealth builder.

Rule #6: Diversification
Diversification won't always save you, and you need more of it than you think. While being diversified is always a good thing, it doesn't prevent you from getting hurt, especially in today's economy. In the recent past, investors were very risky, throwing their money at anything that might give them some sort of return; however, now, all they want is safety with their money. But now that money is moving more quickly, you must work hoarder at diversifying your funds than before. To ensure this, first look to see if you already own some mutual funds and buy other different funds. Then, put that together with a high-yield fund and a broad U.S. bond fund and you will be as diversified as you can get.

Rule #7: Retirement
Retiring early is a problem. Workers have constantly been trying to beat the system by quitting early, feeling very confident that their investments are more than enough to help them get by. However, more than 50% of early retirees leave work before they intend, and, of those, 9/10 leave because of illness or downsizing. Prospects for those with a shot at healthy early retirement have diminished. Some think that delaying retirement just one year can greatly increase annual retirement income and that holding a high-paying position is good. But, in reality, well-paid older workers are more vulnerable and much can actually be gained by finding another job, even if it pays less, and it may even still come with health care which is all the better. No matter the benefits, however, it is always best to plan to worker longer.

By: Dan Hughes

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