Understanding Risk in Financial Alternatives

Tired of riding the Wall Street Roller Coaster? Do you think there has to be a better way? There is.

Is your Financial Advisor only talking to you about Traditional financial assets? CDs, Annuities, Mutual Funds? The trade-off for earning a better return on your retirement savings is usually to accept a greater amount of risk… A lot of risk. Wouldn’t it be great if you could earn better returns without increasing risk? The best way to earn good returns while managing risk is by utilizing financial alternatives as part of your overall retirement planning strategy.

An Understanding of Risk

To understand the value of Financial Alternatives, we need to be able to understand risk. Financial risk is the likelihood of an asset’s value to be less than what is expected at the time an owner wants to sell it.

Let’s look at some different ways of investing in real estate to illustrate one way that we can manage risk. Each of the investors is looking at the same investment. But because they are taking three separate approaches to investing, they are going to have drastically different outcomes. The investment is a single family home selling for $100,000 that will make a nice rental property. The year is 2006 and the crash of 2007/8 is right around the corner unbeknownst to each of them. The house is located in South Florida and will lose 30% of its value when the housing market crashes.

Let’s look at “Bob” first. Bob has $100,000 of cash saved up in a self-directed IRA. Bob’s IRA purchases the property. When the crash hits, the value of the house drops to $70,000. Since he hasn’t financed the purchase, he has not “lost” any money yet. As long as the rents cover property taxes, insurance, and any other holding costs, he wont lose any money unless he sells it. He has lost $30,000 of equity in the property but still has $70,000 of equity.

“Fred” only has $35,000 that he has saved up. He secures a private loan for 65% of the purchase price. He has $35,000 of “Equity” in the property at the time of closing. But when the crash hits, his “Equity” drops to only $5,000. Like Bob, he won’t suffer a loss unless he sells the property. But if the tenants leave and he can’t afford the payments on the loan, he will likely lose 100% of his savings.

“Tom” was the private lender that loaned Fred the money to purchase the investment property. Tom does not have any “Equity” risk. From his perspective there should only be two outcomes: (1) Fred pays the 10% interest on the private loan, or (2) Fred defaults on the loan and he takes the investment property securing the loan. Tom didn’t anticipate the large decline in the housing market, but his loan is still secure even after the decline in the market. He will come out whole regardless of what Fred does.

Same house. Three different ways of investing in real estate. All have varying degrees of risk. Tom is walking away whole and earned a great rate of interest on his loan. Who would you rather be? This depends on your investment goals. Maybe the shot at a huge return was worth the risk of losing everything for Fred. Maybe this was just his “play” money. But if you’re someone whose financial knowledge is limited to all the typical banking, insurance, and Wall Street options, wouldn’t that risk/return profile of Tom’s private loan be very attractive? And if you are someone who found this page while researching Alternative Investments, you already suspect there is a better way. Download the Guide to Financial Alternatives to learn how you can access the investment choices of the Financial Elite.

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No Rendering of Advice: The financial content in this document is provided for your personal education. It is not intended for trading purposes, and cannot substitute for professional financial advice. Always seek the advice of a competent financial advisor with any questions you may have regarding a financial matter. Information in this document is not appropriate for the purposes of making a decision to carry out a transaction or trade nor does it provide any form of advice (investment, tax, or legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments, or products.

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