Risk Tolerance
To simplify the concept of risk tolerance, think of it as measuring how much volatility you can stand before you want to cash out. The riskier an investment is = the higher the return potential = the higher the volatility. “OK,” you say, “I can’t stand any volatility so I plan to sell all my stocks and transfer the proceeds to my savings account.”

Stop there. It’s not quite so easy. And repeat: “Stock market volatility doesn’t imply direction of the stock market – it’s the price we pay for a higher return.”

Return on Investment
Most of us invest because we want our money to grow. We want it to outpace inflation, to fund our key financial goals and to enable us to maintain our lifestyle in retirement. To understand how much ROI you need (and consequently how much volatility you will need to withstand) a few numbers are critical to know: How much you have now; how much you can add in the future; how much you will need in the future; and when you will need it.

Risk/Reward
If you are young and have many years ahead to save and invest, or if you have been a disciplined saver and investor, you may not need as high an ROI to reach your goals. If the volatility of the markets gets to you, you can rebalance into a lower-risk, lower-volatility portfolio. (This is accomplished by increasing your allocation to bonds or cash-like investments.) However, if you run the numbers and realize you have some catching up to do, seriously reconsider your desire to “run for the hills” and maintain an allocation to stocks.

Important Caveat
When determining your risk tolerance and need for ROI, keep in mind that the stock market isn’t the place to invest money in stocks that you’ll need in the short term (in 3–5 years). For example, retirees would be wise to keep 3–5 years of living expenses in very safe investments. A prospective new homeowner wouldn’t want to invest their down payment in stocks. In addition, it’s just smart to maintain an emergency fund of six months to a year’s worth of living expenses in cash-like investments.

The charts and statistics below illustrate the long-term return potential of stocks, bonds and cash.

Market correction: refers to a “mini-bear”  market which isn’t expected to turn into a long-term bear market (down market), but it can be a predictor of worse to come. The phrase “it’s just a correction” is commonly heard when markets are dropping (by 10-20%) – but this is a best guess at the time and only future stock market activity can determine the true outcome.

Double-dip: no, it isn’t your stomach doing a flip-flop when the Dow plunges over 500 points in a day. The term refers to a double-dip or W-shaped recession where the economy emerges from a recession, then goes on to a brief spurt of growth but then falls back into a recession.  We don’t know if we have double-dip yet – it’s too soon to tell. The Great Recession which lasted from December 2007 through June 2009 was the worst since WW II. A recession is identified by a long period of falling activity visible in real GDP (Gross Domestic Product) growth, falling employment, income and production.

Bear market: a declining stock market over a period of time and some say defined  as a  price decline of 20% or more over at least a two month period.
New to me:  this market trend is also referred to as a “Heifer Market!”  Bear markets usually accompany recessions and periods of high unemployment or inflation. The bear market that coincided with  the Great Recession started with the Dow at 14,164.43 on October 9, 2007 and ending on March 5, 2009 at 6,595.44.

Bull run: refers to a  “bull market” which is a rising stock market over a period of time. The last bull run started in March of 2009 when market pessimism reached its lowest point. To be determined is whether the market drop of last week is “just a correction” during a bull run,  or the start of a new bear market.

Non-farm payroll report: an employment report released  by the U.S. Bureau of Labor Statistics on the first Friday of every month. It heavily affects the U.S. dollar and bond and stock markets when it is released. Last Friday’s report was the one bright spot in a bad week when it was announced that the U.S. economy had added 117,000 jobs in July – higher than expected. From 1939 to 2010, non-farm payroll averaged 116,870 jobs reaching a high of 1,114,000 in September of 1983 and a low of -1966 jobs in September of 1945.

S&P’s AAA rating vs. AA+ rating:  Friday, August 5,  Standard & Poor’s took the unprecedented step of lowering the top credit rating for U.S. long-term debt (notes and bonds that come due in more than a year). A downgrade is basically a warning to buyers that there is an increased chance (however slight) that they won’t get their money back and in theory should lead to higher borrowing costs for the government as investors will want to earn a higher interest rate for the increased risk. The 10-year Treasury note is considered the basis for all other interest rates so higher rates on it could mean higher rates on everything from mortgages to car loans, to borrowing costs for state and local governments and companies.

But it’s not clear that S&P’s downgrade will have an effect on rates. Treasury securities are still considered one of the safest investments in the world. As stocks plunged the last two weeks, the price of Treasurys soared because demand was high, even though investors knew there might be a downgrade. Since yields on debt securities fall as prices rise, the yield on the 10-year note dropped from 2.96 on July 22 to 2.39 on Friday.  The reality is that no other market is as large or as liquid as the U.S., even though it has its own set of problems.

The next weeks and months will determine whether the bull or the bear prevails and whether fiscal or monetary policies are instituted that redirect the U.S. economy (and yes, I will explain fiscal and monetary policies in a future Finglish tutorial). Stay tuned for “Finglish” tutorial #3.

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Economists call the U.S. type of deficit a “structural deficit” because it isn’t temporary; the U.S.government habitually spends more than it takes in. Imagine if you ran your own personal finances this way. It would mean you spend more than you make each year and never pay your debt off—it just grows. Your creditors wouldn’t allow it and bankruptcy would surely be the outcome.

In The Ten Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now, Russ Koestrerich takes on this issue in straightforward prose that even a person unfamiliar with deficit economics can understand. In the first few chapters he explains the what, why and how of the U.S. deficit problem. He attributes the large and growing deficit to entitlement spending: revenue spent on Social Security, Medicare and Medicaid, compounded by our politician’s unwillingness to take action to reduce and control this spending. Koestrerich’s premise is that the largest pieces of the deficit pie, entitlement spending, along with the interest expense on existing bonds and defense spending, are politically untouchable. No politician wants to be voted out of a job.

Koestrerich concludes that the deficit isn’t going away and the result will be higher interest rates, slower economic growth and inflation.

In Chapter 2, Koestrerich explains why this matters to you—why slower growth, higher interest rates and inflation will dramatically affect the U.S. standard of living. As more government spending goes to paying interest on the debt, there will be less spending on more productive areas, such as job creation, education and infrastructure. Taxes will inevitably rise as a way to fund the deficit, hurting business and households alike. Higher deficits lead to higher interest rates on government debt which then extends to higher rates on consumer loans such as mortgages, auto and student loans. And in the worst outcome, inflation will start to rise, and each dollar will buy less goods and services, stretching already tight household budgets to a breaking point.

If you believe in Koestrerich’s worst case scenario, then Chapters 5 to 9 are for you.In them, he outlines investing strategies that can potentially protect your capital and make money in a deficit-run economy:

Bonds:

• Reduce bond holdings, particularly U.S. Treasuries.
• Focus your bond portfolio on shorter maturities.
• Build bond ladders.
• Raise allocation to municipal bonds.
• Favor corporate bonds over government bonds.
• Add international (including emerging market) bonds to your portfolio mix.
• Add TIPS (if held to maturity).
• If you need income, look to preferred and dividend paying stocks as bond substitutes.

Stocks:

• Increase your exposure to stocks outside of the U.S.
• Favor regions with better growth prospects and less debt, i.e. Canada, Australia, Germany, Hong Kong and Singapore.
• Own stocks in countries that produce commodities, particularly energy, i.e. Canada and Australia.
• Focus on U.S. companies that are large exporters of goods or services.
• Give more weight in your portfolio to emerging markets, i.e. Brazil.
• Overweight stocks that are more resilient to rising rates such as technology, energy and healthcare and own less in utilities, financial and consumer discretionary stocks.

Commodities

• Allocate a percentage of your portfolio to a broad commodity basket and gold.

Real Estate

• Buying a larger home, a second home or some commercial property is a good strategy in the event of higher inflation, but buying REITS is not.

Koesterich does an excellent job of describing the ways to invest in these different asset classes and the book is a useful investment primer. He explains his recommendations in just enough detail and again, in prose that most investors can understand. I would recommend this book to anyone who wants to get a deeper understanding of our current economy and ways to invest, whether you believe we are on the road to a deficit debacle or not.

Note:  This book was provided to me free of cost by McGraw-Hill. Any investment strategies discussed above are not recommendations. Consult your financial advisor or conduct your own due diligence to ensure investments are appropriate for your risk tolerance and investment timeframes.

What Exactly Does it Mean to be Rich? Ramit Sethi Tells All in His Book

Until a few months ago, I hadn’t heard of Ramit Sethi (pronounced Ra-meet, Say-tee) and his blog www.iwillteachyoutoberich.com or his book of the same name. Then one day while I perused the book section at Costco, there it was – boasting a bright orange and yellow cover with black print. It practically screamed out at me. “I WILL TEACH YOU TO BE RICH.” My first thought was, “that sure is an obnoxious title.”  But being the personal finance junkie that I am, I chucked it into my cart in hopes that I would learn something new and share it with my clients.

After reading the first few pages I knew this book was different.  It’s written in an irreverent, breezy style and I found myself nodding my head and thinking to myself, “I so agree with this” as I read each paragraph. It’s written for people in their 20’s and 30’s (Ramit himself is 27) but this book is a great guide for anyone who is struggling with getting their personal finances in order.  It offers great, solid, no-nonsense advice, and an easy to implement 6-week action plan, plus lots of motivating talk about building a life that is “rich.”

Ok, I’ll admit it. I was fooled by the title, which of course is exactly his intent.  A rich life in Ramit’s world doesn’t necessarily mean lots of $$$, it means living the life that makes you most happy – which is different for each person.

Ramit is passionate about two things. He wants younger people to take action NOW and build a solid financial foundation (and he gives them the tools and specific advice to do so) and he is passionate about exposing the financial industry’s flaws. He is determined that his audience doesn’t  fall prey to the nefarious practices of some advisors and institutions.  He doesn’t like big banks, credit card companies, big brokerage companies and most financial advisors (although he does concede that “if you are determined to get professional help, begin your search at the National Association of Personal Financial Advisors (www.napfa.org).”  Full disclosure: I am a NAPFA advisor.

A couple of weeks ago, I was fortunate to have the opportunity to interview Ramit about personal finance philosophy at  the Commonwealth Club of California http://www.commonwealthclub.org.

I wasn’t surprised to find him smart, witty, engaging, and articulate. I asked him to describe his 6-week action program in 5 sentences or less. He said, “I can do it in 5 words.” He then proceeded to do it in 4, “Automate, Negotiate, Spend Consciously.” I asked him  if he was rich. He said “….money is a part of that, but it’s a small part. People seem to think that being rich is only about money, but that is simply not the case.”

To learn more about Ramit’s personal finance philosophy and system, you can buy the book at Amazon.

Or, read his blog or view this video on the Commonwealth Club youtube channel.

Teaser from the book:

Week 1, you’ll set up your credit cards and learn how to improve your credit history (and why
that’s so important).
Week 2, you’ll set up the right bank accounts, including negotiating to get no-fee, high-interest accounts.
Week 3, you’ll open a 401(k) and an investment account (even if you have just $50 to start).
Week 4, you’ll figure out how much you’re spending. And then you’ll figure out how to make your money go where you want it to go. In Week 5, you’ll automate your new infrastructure to make your accounts play together nicely.
Week 6, you’ll learn why investing isn’t the same as picking stocks—and how you can get the most out of the market with very little work.