Sushi Money

I spent some time this week working on Part II of my view on setting financial goals. It was a busy week however, and presented much opportunity for thought with all the market turmoil. Obviously we live in uncertain times. Instead of a discussion of financial goals this week, it seemed a better time to look at the mortgage issues and consider market risk tolerance. Normally we think of risk tolerance only in terms of investing in the stock market or with mutual funds. Some people say real estate is the ultimate hedge against risk and inflation over time. Maybe, but not unless you have a long time to own it. On a nationwide basis, I would argue that the market for speculation and flipping of real estate is pretty much over. There are a lot of people who invested in real estate and are now making payments on an investment property because they didn’t consider the risk of owning that asset. Many are giving those properties “back to the bank” because they can’t make the payments on them. In the fast moving real estate market from 2000-2005, risk was not something people considered in terms of real estate. The market was “too good” and it was “too easy” to sell a home.

Now we have lenders concerned about risk to their own portfolios of mortgage-backed securities, and an illiquid bond market. Because of the subprime lending blowup, banks and other lenders are wary of taking on new loans. They are demanding a premium both in terms of borrowers with excellent credit scores and higher interest rates on their loans. Many people are trying to secure a new mortgage to purchase a home, while others are trying to refinance their mortgage on their present home. But in both cases, the mortgage climate has changed, making it difficult… probably for many years. You may have read the recent Yahoo article Mortgage Mess Creates Lending Drought, which sums up the issues facing mortgage loan borrowers pretty well. The article above makes a good point however that the current lending climate is not very different from that of the 1980’s and 1990’s. I remember working through a mortgage application in the early 1990’s where the lender picked through everything with a fine-toothed comb. I almost didn’t get that loan because of tiny blip on my credit record from years earlier. I had to scramble to get a letter from a long-gone creditor that stated my account was paid off. It didn’t matter whether it was correct or not… my credit record showed it was outstanding.

What can we do about a challenging lending climate? Not much in the short term beyond making sure that if you’re buying a house, that the mortgage contingency is quite specific in case you cannot get that loan. Sellers are going to have to work with buyers because the process may take a bit longer. If you are buying a home this year or next, do your best to clean up your credit record and make sure there are no outstanding issues or red flags. Also, work at paying down debt to lower your debt-to-income ratio.

There’s lots of advice on the net for how to improve your credit score, and having an excellent credit record is obviously very important. It’s also time to be realistic… most people are going to need to pay 10% to 20% down on their home, and the lender will look very closely at income to ensure qualification is accurate. These days the credit rating agencies are required by law to investigate and report back about any item on our credit record we question. But if you haven’t already checked your credit record, the time to find this out is not while applying for a mortgage or trying to close on a home. Sometimes it takes several weeks or more to get things in order, so it pays to do your homework before applying for a mortgage. What does all of this mean to me personally? I think it means the easy money party is over. In other words, too much debt on the family balance sheet could prevent us from buying, or refinancing, a home or other major asset. It also means that the stock market is going to continue being very volatile over the next 6-18 months. The worst case indicates a recession and severe contraction regarding consumer spending over the next year or two. In that scenario I see the housing market remaining depressed and the global economy slowing down. Many “doomsayers” believe inflation will return with a vengeance. I don’t know about that, and not being an economist, I won’t prognosticate further.

I’m a long-term investor and homeowner, and will try to make decisions appropriate to the long-term. And as well as I know my own limitations, I also know my personal tolerance for risk. That brings me to my real point… in today’s market climate, if you’re going to be investing in the market- any market, you absoultely must decide what your tolerance for risk is. The time to decide you are not comfortable losing money in a particular market investment choice is ideally before you put money there! But most of us learn things a little harder, through experience. Knowing our risk tolerance is not hard, but making decisions appropriate to our risk tolerance often is.

Risk tolerance is a very personal thing, and there are few right answers. What is right for you may not be right for me. What is right for your spouse may not be right for you, so you will need to strike a balance or an agreement for your investing goals and allocation. Risk tolerance is also tied to the time horizon for your investment goals. If you’re saving for a down payment on home, your risk tolerance should necessarily be very low and your assets should be in a savings or money market account. If you’re examining risk tolerance in terms of retirement in 20 years, that presents a whole new perspective. The ancient Greek saying “Know Thyself” is very appropriate. We are trying to work with a level of risk that is appropriate to our goals, time horizon and personal level of comfort. Many studies have been done to investigate consumer risk tolerance, and basically the studies show that people are normally far more conservative than they think. In other words, we often think we are willing to handle degrees of risk, but when it comes to losing money, we are not prepared for risk at all. Here are some tools you can use to analyze your own tolerance for risk:

MSN/Money Online Risk Tolerance Quiz: A quick online assessment of risk tolerance.

The following are printable .pdf files:

Investment Risk Tolerance Quiz: An excellent risk tolerance quiz courtesy of North Dakota State University, by J.E. Grable and R.H. Lytton.

Risk Tolerance Quiz: This is a useful risk tolerance questionnaire from Richard D. Margarian. Use your answer choice as the points for each question, then total them up at the end.

Retirement Risk Tolerance: A short analysis form that looks at risk from a retirement goal perspective.

There’s also few things better than a good second opinion. If you want objective advice and a closer examination of risk and asset allocation, find a professional Certified Financial Planner in your area using the Financial Planning Association’s search tool.

1 comment - Post a comment

« Sage Advice | Financial Confidence In Absentia »