Financial Risk Management: What Is Discretionary Capital?

When we think about financial risk we think about the normal risk factors associated with
securing a return that will exceed inflation, or when travelling frequently or investing in foreign
markets 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 from
investments the value of the investment have gone down (market volatility); then finally, there is
the 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 away
the capital we need to build our financial futures.

When researching the more affluent investors on how they achieved financial security, a
common 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, a
saving plan for every extra penny they earn.

Contrast this to the all too frequent; spendthrift behaviour, excessive credit card debt, the
unsecured line of credit is stretched to the limit, and no active plan of paying down debt. The
emphasis 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 is
my 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, very
often there are obvious weaknesses in their plan; if there is a plan. The most common is the lack
of existence of a simple savings account, to save at least 3 months living expenses. As this is
such 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 $19,000
in case you lose your job, or when you need the funds most. These two financial instruments
provide the buffer you need to secure the cash flow for your family. This opens up the family
budget 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 insurance
plans, and at least 10% for your retirement plan.

The money left after you’ve paid for food, shelter, clothing, insurance plans and retirement
savings is your discretionary capital; for example, gym memberships and social events, etc. This
is where the more affluent start to watch their budgets to see if they have some left for additional
savings.

Depending on your lifestyle most people in Calgary need from $3,000 to $6,000 per month to
budget for basic living and lifestyle expenses. We all know that the cost of living is high; yet it
remains important that you "cut your cloth" according to your income, and you get into the habit
of 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 reason
for 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 acquire
ever 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 aversion
of 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