The building collapse in Surfside, Florida, was horrifying to see. My heart goes out to all of the families affected.
You would expect that in a country as developed as ours, a building collapse isn’t a risk you’d need to consider. I’m not the only person now looking at my own house and wondering how stable my roof is.
When a high-profile tragedy strikes, it can be a wake-up call to take a look at our own lives and assess the risks we’re carrying. We can’t eliminate all risks … and even if we could, we wouldn’t want to. After all, there’s no return without risk. This applies to our personal lives every bit as much as it applies to our financial lives.
But here are a few financial risks to ponder.
Financial Risk No. 1: How Much Is Your Life Worth?
I think about this one a lot. I have three kids now, and if I were to drop dead of a heart attack tomorrow, my wife would not be able to replace my income. For my family to have security, I need life insurance … and a lot of it.
There’s no real “rule” here, but I have my own rule of thumb: Take your current annual salary and divide it by 0.05.
To keep the math simple, let’s say you earn $100,000. That amount divided by 0.05 gets you $2 million.
That’s roughly the amount of term life insurance I’d recommend.
Why? Because $2 million invested at 5% would get you to $100,000 per year, replacing your salary.
As for the term, that can be tricky. I have a baby. So in an ideal world, the term of my policy would be at least 20 years. My wife would need the cash to raise the kids. And 20 years from now, my nest egg should be big enough to support the family. So if I’m uninsured then, it’s no big deal.
Your situation might be very different. But the key is making sure you have enough insurance to replace your income during your working years. It’s income replacement, not an investment or savings plan.
Financial Risk No. 2: And Your Health?
I could talk anyone’s ear off about health insurance strategies if they’d let me. But I can sum it up like this: Treat health insurance as insurance and not as a prepaid spending plan.
Insurance is designed to protect you against a catastrophic loss, not against everyday expenses. Just as your homeowners policy is there to protect you from a fire and not from every Kool-Aid spill on the carpet, you need health insurance to protect against catastrophic illnesses. You want to make sure you have good treatment if you get cancer.
For these reasons, I prefer high-deductible plans. They’re cheaper, and the monthly premiums don’t cut into my budget all that badly. I’m comfortable risking several thousand dollars per year on the deductible in order to pay a lower monthly bill.
But I’m also healthy. If you have special health needs, this might not suit you. You’ll need to run the numbers yourself. But as a general rule, healthy people should go for high-deductible plans.
No. 3: What About Portfolio Insurance?
Losing your nest egg in or close to retirement due to bear market losses is a real financial risk. This is truer today than ever, as a lot of investors are heavier in equities than generations past. Low bond yields have forced a lot of investors into taking more risks.
That said, I don’t recommend portfolio insurance in the form of put options in most cases. And the reason is simple: The insurance is just too expensive to make sense.
Because investors are naturally nervous, they tend to overpay for portfolio insurance, bidding up the cost of put options. I know plenty of investors that take advantage of this by selling puts rather than buying them. (In this case, the investor is acting as the insurance company rather than the insured.)
There are better ways to protect yourself outside of buying puts. To start, you should keep your allocation reasonable. If you’re 70 years old, you shouldn’t have 100% of your portfolio in the stock market. Most at this age shouldn’t have more than about 60% invested in stocks, and even that might be a little on the high side for some investors.
So, step one is to simply keep your allocation modest.
You can also use shorter-term trading strategies such as those our chief investment strategist Adam O’Dell writes about. Again, you should be smart and keep your position sizes modest. But adding some short-term strategies within the context of a broader portfolio can reduce your risk if those strategies are minimally correlated to the market.
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To safe profits,
Charles Sizemore
Editor, Green Zone Fortunes
Charles Sizemore is the editor of Green Zone Fortunes and specializes in income and retirement topics. Charles is a regular on The Bull & The Bear podcast. He is also a frequent guest on CNBC, Bloomberg and Fox Business.