Recs

3

Your Real Risk Tolerance

I have some friends, a married couple -- let's call them Mr. and Mrs. WhatTheHeckAreYouThinking (the Whayts, for short). The female member of this couple (the other member is a male, not that there's anything wrong with that) has often remarked to my wife that the balance in the Whayt family checking account hovers close to zero.

Hey, it's tough to make ends meet, especially when you have kids (as the Whayts do). And the Whayts have been through some rough times. Mrs. Whayt is unable to work due to an ailing back that has required several surgeries.

But when Mr. Whayt and I have stood around talking about guy stuff (i.e., anything that is powered by or emits gas, such as vehicles and the Washington Redskins), he has mentioned that he earns about $80,000 a year. (Has anyone else noticed that more and more people are using the word "vehicle" when a perfectly serviceable monosyllabic word like "car," "van," or "horse" would do?) Given that the median income for a four-person family is less than $70,000, the Whayts seem to be earning enough. And they bought their house years ago, before the housing boom, so their mortgage must be low.

Or so you'd think.

It turns out that the Whayts have very little equity in their house, despite rising home values and years of mortgage payments. That's because they rolled $60,000 worth of credit card debt into their mortgage. Did this have anything to do with medical bills? Perhaps, but Mrs. Whayt told my wife that most of it was accumulated through purchases of stuff like furniture and clothes.

A few days after the Whayts told us about their debt, they left for Florida to spend a week at their time-share. But before they left, Mr. Whayt bought new golf clothes and shoes, and Mrs. Whayt spent some time at a tanning salon.

The real risks
If you've ever read an economics textbook, what you probably found -- when you weren't nodding off and drooling -- were plenty of discussions of risk: currency risk, credit risk, systematic risk, Hasbro's (NYSE: HAS  ) Risk, etc. Most of these have to do with investments, and essentially address volatility -- or what can cause an asset to decrease in value before you sell. (Heck, even we Fools discuss such thrilling concepts as "beta.")

And any financial advisor worth his weight in monogrammed undergarments will discuss "risk tolerance" with a client -- how much up and down a client can stomach in his portfolio. Such a discussion will address a person's ability to withstand potential pain in the hopes of eventually being able to purchase more pleasure. In other words, can an investor accept the 2000-2002 stock market in return for the 1995-1999 and 2003 stock market?

But there are worse things that can happen than a 25% drop in your 401(k), and they can have just as much impact on your family's net worth. They also come down to pain and pleasure, but in different ways. In the case of debt, can you delay current pleasure (i.e., cutting your spending) to avoid future pain (declining net worth and perhaps bankruptcy)?

The Whayts are great people. They are helpful friends, they have enjoyable kids, they obey the major laws, and they contribute 10% of Mr. Whayt's salary to his 401(k). They also can deplete the equity in their home and still go on vacation. That takes an enormous tolerance for debt. And make no mistake about it: Debt -- even "good" debt, like a mortgage -- is risky. It increases your financial obligations, lowers your credit score, and compromises your goals (at least the ones that require money, such as retirement and college).

Paycheck risk
As mentioned earlier, most discussions of risk in financial circles concern investments -- the risk to what you already have. But before there were investments, there was income. After all, you have to earn something before it can be saved and invested. But you don't hear much discussion of "paycheck risk" -- the risk that your income might not always be coming in.

This is the risk the Whayts have to worry about. They are able to have virtually nothing in their bank account yet still go to Disney (NYSE: DIS  ) World because Mr. Whayt earns enough to cover the debt payments. But if something happens to that paycheck, then it will be bye-bye Mickey -- and maybe farewell 401(k), since they'll need money to pay the bills.

Loss of income is how many people cross over from the verdant hilltops of the debt-free to the barren valley of the debt-burdened. A layoff, a disability, or (the worst-case scenario) a death can transform a family that is living below its means to one that is living beyond its means -- mostly because the means are gone.

So don't be too smug about the Whayts. I certainly am not. (After all, if I'm so smart, why are they in Florida while I spend approximately three hours a day trying to put coats on my kids?) Even if you're not overspending, you might not be so far from borrowing thousands of dollars yourself.

Unless, of course, you don't have the tolerance for such risk and you've taken the proper steps, such as:

  1. Establish an emergency fund: Set aside a pile of cash -- enough to cover three to six months' worth of expenses -- in a safe, easily accessible place. Visit our Savings Center for the best options. This money can cover the short-term bills while you find another job, recover from disability, or wait to receive the life insurance payment. Which is why you should...
  2. Get insured: According to the Social Security Administration, one in seven workers dies before age 67, and almost three out of every 10 of today's 20-year-olds will become disabled before age 67. There's a real risk (there's that word again) that you will be unable to earn a paycheck at some point in your life. Visit our Insurance Center for the lowdown on life and disability insurance.

We can't protect ourselves from every risk -- after all, most insurance policies specifically disclaim any responsibility to cover damages due to Armageddon. But most of us are at risk of losing our income, and we can take reasonable steps to contain the consequences of such a calamity.

On the other hand, owing hundreds of thousands of dollars amplifies those consequences. If that's you, visit our Credit Center for help. It's a risk you really shouldn't tolerate.

Robert Brokamp knows the Whayts don't read his columns, and he hopes it stays that way for at least a little longer. He doesn't own any of the companies mentioned, but he used to own Risk. The Motley Fool is investors writing for investors.


Read/Post Comments (0) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 493879, ~/Articles/ArticleHandler.aspx, 8/27/2014 5:07:52 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Robert Brokamp
TMFBro

Today's Market

updated Moments ago Sponsored by:
DOW 17,122.01 15.31 0.09%
S&P 500 2,000.12 0.10 0.00%
NASD 4,569.62 -1.02 -0.02%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

8/27/2014 4:00 PM
DIS $90.37 Up +0.35 +0.39%
Walt Disney CAPS Rating: *****
HAS $52.26 Up +0.03 +0.06%
Hasbro CAPS Rating: ****

Advertisement