Should you own Zombie Apocalypse Insurance?: Four risk mitigation disciplines to get familiar with Zombie Insurance exists…yes really, if only as a marketing ploy for insurance shops. But it gives us a great reason to discuss the different types of risks, and the disciplines that exist to mitigate the given risk set. Zombie Apocalypse Risk is both an unmitigable risk, there is little if anything you can do to avoid an apocalypse. And it’s also not cost-effective, the replacement of anything lost in the apocalypse is unlikely – the insurer after all is very likely a zombie in this scenario. So it’s an easy “don’t buy it” recommendation. But how about others’ risks? Tax, fire, disability, market, etc. all exist daily, and all have nuanced methods for handling them. Cost-Effective Not Cost-Effective Mitigable Homeowners Insurance (Buy it) Annual Downside Puts for Market Protection (likely don’t buy it) Unmitigable Life Insurance (Buy it sometimes) Zombie Insurance (come on?!?!) Effective risk mitigation requires understanding both the financial risk at play and the full length of consequences that result from the strategy a person or family chooses. Tax Risk is a great topic to think about. Most investors “Accept” Tax Risk and pay their taxes at the end of each year depending on their income and gains from the year before. You bought the stock, it went up 20% forgo 5% as a cost of doing business and pay your income and gains tax on it. Some Investors might “avoid” tax risk by using investment strategies, 401ks, IRA’s, or other legal means of tax avoidance. Further, still, some may limit their tax exposure by using several different investment strategies and holding strategies by spreading out the tax risk over time or using income streams that are taxed in different ways. Further still, some may use tax risk transference through trusts, gifting, and other asset location strategies to manage it. Tax risk is just one flavor of risk, but almost every conceivable risk can be filtered through the strategies below to make the existence of risk far more tolerable. Risk Acceptance There are several risks you “accept” every day regardless of the calculus. The risk of an airplane part striking you at a wedding is really low, so you simply accept that risk and head outside. The risk of a single down month in the stock market is high, and so is the cost to insure against it. Risk acceptance as a strategy is about balancing the likelihood of that risk happening, the financial impact it would have, and properly pricing the below strategies to handle the risk. Risk acceptance does not reduce any effects however it is still considered a strategy. The “acceptance” strategy is a common option when the cost of other risk management options such as avoidance or limitation may outweigh the cost of the risk itself. A company that doesn’t want to spend a lot of money on avoiding risks that do not have a high possibility of occurring will use the risk acceptance strategy. Traditionally, risk acceptance can be the key to investment upside. The performance of the S&P 500 is a great example. If you simply accept the risk you will have more up years than down years, and the result will be net returns of about 9% year over year. If you used financial products to mitigate the financial consequence of a down year, it could cost you between 8-10% of the return to fully inoculate the risk. Leaving you with little to no return. So there are several times where risk acceptance is the more rewarding outcome. Risk Avoidance The risk management effort is a process to target and control the damages and financial consequences of threatening events, risk avoidance seeks to avoid compromising events entirely. This is equally an activity you likely engage in regularly. You, like me, may not attempt amateur base jumping daily for a myriad of reasons. This simple act of not participating is a risk management strategy. When determining how you will approach risk, it’s important to not confuse the strategies of risk avoidance and risk acceptance with a very different concept “risk ignorance.” Risk ignorance stems from two very different but connected problems. The first is a knowledge gap, this is a problem with risk-takers’ understanding of a market, investment, process, etc. where they simply don’t have the skill set required to uncover and handicap all of the potential risks. When I don’t work on the inner workings of my vehicle it’s an acknowledgment of that knowledge gap. The second gap, and likely harder to uncover, is a competency gap. This is the knowledge that the risk exists, but poor reconciliation of an investor or person’s skill to overcome the difficulties. Think about new building construction. The builder might know that the risk of financing can fall through, so they have crossed the knowledge gap, but if a project still falls through because of a lack of coordination, effort, or something else entirely it fell victim to mispricing of the competency gap. Risk avoidance is one of the least understood methods used by investors and as a result drives two negative behaviors. Rationalization or compartmentalization. In this first, investors fall in love with an idea, stated returns, or a story and begin down a path they believe is “risk avoidance” but is actually rationalizing them into risk ignorance. The second “compartmentalization” is a form of risk avoidance but for the wrong reasons. An investor may not understand a product or service and as a result, shut down a whole category of strategies. A great example is in derivatives, many people attribute the financial crises to derivative products and thus write off the whole group regardless of other tactics that might support their goals. A lack of sophistication and understanding of risk is a common source of aversion, failure to change advisors, or even seek investment advice in the first place. Risk Limitation Risk limitation is the most common strategy.