When it comes to financial planning, one of the most important areas for clients
is risk management.
We get an awful lot of questions in this area.
Unfortunately, it's routinely one of the most overlooked as well.
Now what do I mean by risk management?
Sure, portfolio risk is one facet of risk management, and one that people
often hear and talk about.
But in a comprehensive financial plan, risk management runs much deeper.
We're talking about job security, protecting hard assets, home and auto -
the list for each person is varied.
Just as fortune favors the prepared mind, so too does risk management.
It's simply a prepared strategy to offset losses when things don't go according to plan.
Generally speaking, there are four common types of risk, but to be clear, they're not
all mutually exclusive.
The first two types are pure risk and speculative risk.
Pure risk relates to a loss when an event actually occurs.
For instance, your house either floods or it doesn't flood.
This type of risk is very straightforward.
And because of that, this type of risk is often easily insurable.
Now, speculative risk is a little different.
As its name implies, it involves speculation - betting on the unknown.
A great example of this would be gambling.
No one's going to guarantee that you win a hand of blackjack.
Of course, while when speculating, you may be able to hedge your risk, generally this
type of risk is very hard to insure.
Next, you have income risk and expense risk, and they are both closely related.
Income risk: this is risk that deals with your earnings.
Can you produce income?
Can you hold a steady job?
Does that job produce enough money for your lifestyle?
disability or aging are things that expose you to income risk.
If you can't work, you incur income risk.
Expense risk, of course, is closely related.
Put very simply, spending more than you have.
This could be voluntary or not.
It's closely tied to income risk because if you can't work, then one
has less money to spend.
The risks are you're unable to pay your bills, get proper medical care, and
take care of loved ones, etcetera.
in order to avoid these pitfalls, you need to have an organized process.
First, you need to identify the nature and cause of the risk.
You need to establish where you are vulnerable.
Then you need to determine how much of that risk you're willing to take and retain.
And after that, you need to deal with the risk that you've chosen not to retain.
So once that's done, you can then use five distinct strategies to
manage and control your risk.
Number one: risk avoidance.
And this is avoiding the activity altogether - you're avoiding the risk.
Examples this would be smoking versus not smoking, skydiving versus not skydiving.
Then we have number two: risk retention.
You self insure.
You are the insurance company.
An example of this might be forgoing long term care because you feel you may not need
it, or you think it's too expensive, so you're going to take the risk on by yourself.
Risk reduction.
This is also known as loss prevention and control.
Insurance companies reduce risk by incorporating the law of large numbers.
They have a lot of people to deal with.
As an individual you might do it a little differently, but you do do it.
And the ways that you do this is by locking your door at night, installing a fire alarm,
or even buying a watch dog.
Finally, the last two are risk sharing and risk transfer.
An example of risk sharing is health insurance.
You pay a portion of the cost, the insurance company pays a portion, you are both assuming
the risk and sharing in the risk.
Risk transfer is a little bit different.
You're actually paying a premium, you're actually paying a fee, and you're allowing the insurance
company to take on all the risk.
So you're transferring the risk to the insurance company, and as I mentioned before, then the
insurance company is using the law of large numbers to mitigate that risk for you.
These concepts and ideas are a great foundation, but individually, you have the power and control
to mitigate and alleviate a lot of this risk on your own.
And it starts with being honest with yourself.
You need to know yourself.
You need to know your limits and you need to self evaluate.
Some ways to start the process off with risk management is to involve the following:
Have a hard, honest look at what you really want, and what you really need, and what you
really want to protect.
When it comes to your job, stay relevant.
You need to stay up to date.
Be informed, be hireable.
Make yourself a valuable asset.
No one cares more about you than you.
Have adequate insurance.
I tell all my clients, "don't just buy insurance.
Understand what you need and why you have it.
If you can't understand the product enough to explain it to a spouse,
that might be a red flag."
Other things, of course, we want to make sure you have an emergency fund,
and of course, limit debt.
Seems pretty obvious, but those are very important things where you can mitigate risk.
Now, you're also going to want to properly allocate your investments,
and have a properly diversified portfolio.
And finally, live a healthy lifestyle.
This can lead to positive results across all facets of your life and possibly be
the greatest risk mitigator of all.
If you have questions, please reach out to us at Pure Financial - we'd be glad to help
you with your risk management plan and your financial plan.