Finance

Financial Risk Management: What Is Discretionary Capital?

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Discover what you can deem to be discretionary capital.
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  Financial Risk Management: What Is Discretionary Capital? When we think about financial risk we think about the normal risk factors associated withsecuring a return that will exceed inflation, or when travelling frequently or investing in foreignmarkets where we are concerned with the value of the Canadian dollar relative to other currencies. Financial risk, at its simplest, means when we need to withdraw money frominvestments the value of the investment have gone down (market volatility); then finally, there isthe risk that I may outlive my retirement savings (longevity).This month I want to focus on something much more simple; how our spending habits eat awaythe capital we need to build our financial futures.When researching the more affluent investors on how they achieved financial security, acommon theme rises to prominence; very clear long term goals, a burning desire to keep to their priorities, living frugally, a good sense of how much they need for food, shelter and clothing, asaving plan for every extra penny they earn.Contrast this to the all too frequent; spendthrift behaviour, excessive credit card debt, theunsecured line of credit is stretched to the limit, and no active plan of paying down debt. Theemphasis is live for the now, focus on fun, find ways to enjoy the money, movies, clothing, or Las Vegas weekends.  It is all too easy without long-term goals, and if we do not have financial instruments to guide our long term plans.Does this sound familiar? You may think yea it’s simple, boring, don’t waste my time, this ismy money; I will do with as I please. But before you know it, you will need those funds.Yet when I sit in front of many families, explaining the basics of financial management, veryoften there are obvious weaknesses in their plan; if there is a plan. The most common is the lackof existence of a simple savings account, to save at least 3 months living expenses . As this issuch a big issue this paragraph should all be in capital letters, this is how important this part of the plan is.Assuming monthly expenses of $3,000 per month, this means a savings account with about$9,000 in it; and then the unsecured line of credit (not to be touched for discretionary spending),which is also critical to every family’s financial plan. In total, these two will provide about $19,000in case you lose your job, or when you need the funds most. These two financial instrumentsprovide the buffer you need to secure the cash flow for your family. This opens up the familybudget to put down a deposit, or pay cash, and keep interest payments down.To further secure the plan, you need to allocate about 10% of your income to pay for insuranceplans, and at least 10% for your retirement plan.The money left after you’ve paid for food, shelter, clothing, insurance plans and retirementsavings is your discretionary capital; for example, gym memberships and social events, etc. Thisis where the more affluent start to watch their budgets to see if they have some left for additionalsavings.Depending on your lifestyle most people in Calgary need from $3,000 to $6,000 per month tobudget for basic living and lifestyle expenses. We all know that the cost of living is high; yet itremains important that you cut your cloth according to your income, and you get into the habitof saving first, before any discretionary spending; or you need to seek supplementary income.The topic may seem simplistic, boring and a waste of time, but this is the fundamental reasonfor financial mismanagement, and the primary cause of the economic meltdown in late 2008;  namely living outside of your means. On average credit card debt ratios alone were 105% of total equity values. The banks allowed individuals, who could not service their debt, to acquireever more debt, via loans and credit cards, until the financial system imploded.Next month we will spend time on the following three questions:Why do some people believe the only way to wealth creation is investing in property?Why do some people loath investing in mutual funds?Why do some people identify direct investing in the stock market with wealth creation?To answer these questions, we need to look into the experiences, preferences and risk aversionof individual investors. We also need to spend time to evaluate risk in terms of the speed of change, and the unpredictability of when the change will take place.Daniel Botha - Sun Life, Calgary
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