A number of years ago, people would "invest" large amounts of their savings into tax shelters without any professional help in assessing the risk. One investor put $7 million of his net worth (100% of it) at risk in a tax shelter in order to defer $2 million of capital gains taxes. He lost the entire $7 million because the syndicators were crooks. A teacher invested $40,000 into a high risk oil and gas drilling program -- and she had to borrow half of that amount. It was lost and the tax benefits didn't make up for it. There were many thousands of people who lost their life savings during the tax shelter era because they didn't exercise reasonable risk management. More recently, a lot of people lost everything by betting on some "dot-com" company or by jumping into the stock market when the values were far above any historic norm. 

During the tax shelter years, I was working with a financial planning group and we developed a system of risk management for investors that was combined with a strategy to minimize taxes. (A copy of a report describing that concept is available from Offshore Press, Inc.))

Basically, we advocated to our clients that no one can honestly claim to be able to predict the future. Investment plans that are predicated on being able to do so should be approached with great caution and no investor should risk more than they could afford to lose in any investment plan that is not subject to the complete control of the investor/taxpayer. Instead, we advocated a defensive structure that would protect the investor from a complete loss of his or her nest egg and from an assortment of diverse economic, political and market risks. 

We counseled our clients to understand that most of us make money in some business or occupation where we have some substantial expertise. Investing is not a substitute for that income producing career. Investing is putting money aside for some future use. Most of the growth in value (or the income) from our savings is compensation for risk or for the use of the savings for a limited time. The  income on most of our investments barely keeps up with inflation after taxes.

Without risk, there is little reward for investors. A persuasive argument can be made that the risk-adjusted rate of return is always equal to the return on comparable government bonds of a similar duration. In other words, if you can make 10% a year from the stock market, half of it is compensation for risk. Somewhere, someone is getting back less than 5% on their stock investments. 

A central element of our risk management concept was that an investor should decide how much he or she could afford to lose in any single investment without having to suffer a substantial and unacceptable reduction in their future retirement income or their estate. For most clients, that was 10% of their net worth. For some others it was 25% or even 33%. 

Thus, it would be prudent to put 100% of a client's assets into a family limited partnership or trust where the client was in control of the investments. Most clients were business owners and were in control of the assets in their business. It would not be prudent to put more than 10% (or 25% or 33%) of the client's assets into a single investment limited partnership, mutual fund, pension trust or insurance policy where the client was relying on someone else to manage the investments. We therefore regarded asset allocation funds as oxymorons. Although the assets within the fund may be diversified, the client is at risk with respect to the management of the fund itself. 

Vernon K. Jacobs

Blatant Self Promotion: This article is a very short description of Risk Management for Amateur Investors by myself and N. Richard Fox.  The entire 155 page book is on the subscriber's restricted web site and is also available in printed form. 

Your suggestions for improving this web site are welcome.  Vernon K. Jacobs, Webauthor .