No matter what you do in life, and in finances, there is risk involved.
The type of risk involved, and your ability to handle it, is likely to vary, depending on the asset and the situation. Before you make a financial decision, make sure you understand the following 3 types of risk:
Inflation/Interest Risk
Many of us completely forget about this type of risk. A number of us remember to consider market risk when planning our finances, but it’s harder to remember to pay attention to inflation and/or interest rate risk.
Basically, this type of risk is what you need to worry about in terms of the way prices rise — and your purchasing/spending power decreases. Your money is worth less over time, so it’s important to ensure that you are earning a yield that overcomes the rate of inflation.
When you concentrate too heavily on assets like cash and bonds, you run the risk of not having a high enough interest rate to overcome inflation. In real terms, you are losing money. It’s important to be aware of the risks that come when you try to play too safe.
Liquidity Risk
On a macro scale, this risk is about the economy. Just after the financial crisis, there was a liquidity issue. Banks were reluctant to lend, and money wasn’t moving through the economy effectively. This made it difficult for people to get credit, and to buy things, and to help the economy recover.
Liquidity risk can also refer to whether or not you can get rid of assets. For instance, having a home can be a liquidity risk if you want to sell, since you can’t just unload it quickly or easily. It’s important to consider liquidity in your own life. Can you access the money in your emergency fund easily when you need it? If an opportunity pops up, do you have the resources to take advantage? Figure out how long it would take to marshal your resources if you needed them.
While too much liquidity usually means you give up the chance for yield, you also don’t want to have all your resources tied up in assets that are hard to convert to cash.
Timing and Situation Risk
Sometimes timing has a lot to do with your finances. When you get paid, when you owe money, and special circumstances that might affect your situation can all contribute to risk in your personal economy. If you are trying to pay down debt, but you keep getting hit with small emergencies, like your car needing repairs, your washing machine breaking, or some other issues, it can really affect your ability to manage your finances.
Likewise, sometimes you decide you need to do something quickly — and you might end up paying for it. I’m going to try to sell my house fast so that I can move out to Pennsylvania with my husband. It’s a situation that, due to timing, is likely to mean an expense for me. It’s not pretty, but my finances can (barely) handle it.
Understanding how these items can affect your finances is an important part of long-term planning. Be sure to consider them in your plans.
Inflation is a big risk that most people seem to miss when planning for retirement or any future purchases. We see inflation all around us, yet it never seems to be thought about in our everyday decisions to save.
The key to successfully surviving a liquidity stress event – something that is a very rare occurrence – is to understand exactly what is meant by “when they become due”. Essentially it means in perpetuity.