The Future of AllThingsFinancial - Part II

Well, I finally bit the bullet and set up an account with DreamHost to host AllThingsFinancial. I'm excited and nervous at the same time. I appreciate all the supportive comments from my first "Future of..." post. They (the comments) were very helpful and aided me in my decision-making. I'm very fortunate to be able to count most of my readers as friends. -JLP

Let's Talk About Risk

In the investment world "risk" is defined as fluctuation. Of course, we are really only concerned with DOWNWARD fluctuation. Anyway, there are many different kinds of risks involved in investing. I'm going to take a couple of posts to talk about them.

I got the idea for this series of posts from Ric Edelman's book The New Rules of Money, which is a pretty good book (I can't say that about the rest of his books). Ric is a financial advisor and author. He also has a website.

So, what are the major types of risk? I'll list them first and then I'll go back and explain each one:

• Default risk - The risk that an investment will become worthless. Does this remind you of Enron or Worldcom? Those people who had all their wealth tied up in those two companies lost it all. However, this risk can be minimized through proper diversification. Had you owned Enron or Worldcom in a portfolio of stocks, the impact of their default wouldn't have been nearly as severe.


• Credit risk - This is the risk that an investment's financial stability might decline. Although this risk involves stocks, it is particularly important to bond investors. If you own a bond in a company who's credit rating gets cut by the bond rating services, the value of your bond is going to decrease. This is another type of risk that can be diversified away.


• Tax risk - The risk of loss due to taxes (income and capital gains taxes). Loss to taxes can be either postponed through tax-deferred accounts like 401(k)s, IRAs, and annuities. Loss to taxes can be eliminated with the use of a Roth IRA or Roth 401(k).


• Inflation risk - A very real risk faced by everyone (some have more exposure than others). This is the risk that an investment's purchasing power will be eroded by rising prices. This is a very real risk to someone invested in interest-bearing accounts. Stocks have been shown to handle inflation risk pretty well as long as the inflation is low to moderate.


• Interest rate risk - The risk that interest rates will rise. If you buy a bond today for $1,000 that pays you 4% per year and then interest rates rise to 4.5%, your bond is worth less than the $1,000 you paid for it. Why? Becuase why would anyone want to pay you $1,000 to earn $40 per year when they could buy a bond for $1,000 that pays $45 per year?


• Currency risk - The risk that foreign currency exchange rates will rise. If you are a US citizen and have an investment in China and China's yuan increases in value against the doller, your investment will decrease in value. (This looks like an excellent follow-up topic)


• Political risk - This risk is related to currency risk. Political instability can be a substantial risk when investing in other countries - especially emerging markets. Diversification can reduce this risk.


• Market risk - This risk has to do with the price fluctuations of the market as a whole. There's not a lot that can be done about market risk except for ignoring it.


• Event risk - The risk that something unexpected and beyond management's control will cause the invesment's value to fall. September 11, 2001 is probably an the example most people think of.


• Prepayment risk - The risk that the investment's principal will be returned sooner than expected. Investors in callable bonds face this risk when interest rates decline.


• Extension risk - The opposite of prepayment risk. In other words, you might not get your principal back as soon as you expected.


• Opportunity risk - The risk that by investing your money in one place you are missing out on the returns "you could be getting" elsewhere. Diversification can rid you of most of this risk.

If you are like me, you probably didn't think there were that many different kinds of risks. These risks are all very real and should definitely be considered when making your investment plans. However, please realize that risk is natural and in most cases if you want a decent return, you are going to have to except some risk.

Tags: Understanding Risk, Risk, Investment Risk

Carnival Submissions for Week 11

Man, it is hard to believe that we have done 10 carnivals already! Time flies when you are at the carnival! Anyway, AllThingsFinancial will be hosting Week 11 on Monday, August 29.

I NEED MORE SUBMISSIONS!

So, if you are a blogger and have a personal finance article that you would like to submit (preferably original material), please send me an email with the following info:

• Your Name


• Your Blog's Name


• Your Blog's URL


• Your Article's Title


• Your Article's URL


• Your Article's Trackback URL (if you have one. If you don't no biggie)


• Your Summary of the Article

Pick an article that you want lots of people to read and send it to me. My deadline is Sunday, August 28, at 5:00 PM Central Time.

Gas Prices

First off, I hate paying high gas prices. I hate it with a passion. However, that doesn't mean we should be rash and blame whoever and whatever for higher gas prices. Really, we only have ourselves to blame.

My local paper has been inundated with letters from people who angry over gas prices. It is sad just how little most people know about economics. Here is one example from today's paper:

I don't understand the price-rising criteria for gasoline. If the station has already purchased the gasoline to sell at a set rate, why does the increase affect the gasoline already in the station's tanks. To me the increase should be on the gasoline that is ordered, not what is already there.

It's kind of like buying bread: On the shelf it's one price, by the time you get it to the checkout counter, there's an increase because of the instability of the flour market?

My response:

Using this woman's thinking, when prices decrease the opposite should be true. When prices fall, a gas station that might have paid more for their inventory would have to keep prices high until that inventory is sold and then they could decrease prices. I wonder how long that would work in the real world?

Although I'm not exactly familiar with the way gas stations set their prices, I would speculate that the reason we don't see wide swings in prices from station to station is to avoid long lines and shortages at some and gluts at others. I'm not saying I agree with it, I'm just saying that that is one way to look at it. I will say that it does seem that prices go up FASTER than they come back down.

Since we are on the topic of gas, I want direct your attention to a pretty good post on the Freakonomics blog critiquing an article (free registration required) that was in the past weekend's New York Times Sunday Magazine. Both (the NYT article and the Freakonimics' critique) are must-reads.

Tags: Gas Prices, Oil Prices, Freakonomics

This Week's Carnival of Personal Finance

Dawn at FrugalforLife has done a great job hosting Week 10 of the Carnival of Personal Finance. Stop by and check it out.

AllThingsFinancial will be hosting next week's carnival. Please start emailing me your submissions (please include "Carnival Submission" in the subject line). My deadline for submissions is Sunday, August 28, 5:00 PM so that I can have the Carnival up at midnight on the 29th.

Building Wealth Doesn't Get Any Simpler Than This

I'm a fan of Scott Burns. When he writes, I read it. Anyway, I noticed that he had an article on the Money Central website today. In that article he talks about how a person (a young person) can become a millionaire if they:

• Work four summers, starting at age 16


• Save the income in a Roth IRA account


• Invest it in a simple, low-cost equity portfolio


• Simmer slowly for 47 years


• Serve ungarnished (and untaxed) at age 67

He then goes on to explain how it can be done. Good information! This is the kind of stuff I like. I think we tend to spend too much time talking about what can't be done instead of focusing on WHAT WE CAN DO NOW!

Tags: Starting Young, Becoming a Millionaire, Investing

AllThingsFinancial Mentioned in the Wall Street Journal

I just want to say thanks to Andrew Blackman at the Wall Street Journal for thinking of AllThingsFinancial when he wrote this column that appeared in today's Wall Street Journal. It's nice to get some recognition.

He did mention one thing that he didn't like about my blog and that's the fact that I don't have my articles categorized. I have to agree with him. I hate that too, but Blogger doesn't have that feature. That problem will be fixed once I change providers. Until then, I'll have to manually organize my posts.