Sadly, many people don’t realize how much risk they are exposed to until something bad happens. As financial planners, we see this all the time; hardworking people with incomplete financial plans that make them vulnerable to any number of risks.
Healthy financial risk management is comprised of three key areas: risk identification; risk assessment; and risk mitigation.
By addressing risk in this way, the chance of being caught ‘naked’ is greatly reduced.
“You don’t know who’s swimming naked until the tide goes out.”
– Warren Buffet
Financial planning is primarily comprised of accumulating, saving and spending money, and there are risks associated with each. The most common way of accumulating money is to earn it through your work. So a major risk for most people is losing their ability to earn an income through illness, accident or a job loss. Without that income, most financial plans are turned upside down, creating a domino effect of challenges for the individual or family.
In saving money, a range of investing risks occurs. Markets—and the stocks within them—can perform badly for any number of reasons. This creates the risk that investments will actually decrease in value instead of increase. Or, when it comes to retirement, the investment growth you expect may not occur, leaving you with less than you need. The list goes on and on.
And finally, spending creates its own set of risks. At its simplest, people may just spend too much and run into debt issues. But more often, it’s the complex challenge of not accurately estimating expenses, which leads to spending more than expected.
Health issues may create additional costs. A leaking roof may create an unbudgeted home improvement cost. A family member’s personal struggle may pose a financial burden. All of these things can create an environment where you are spending a lot more than you anticipated, and that can create major issues for your plan.
Once you understand the risks, the next step is to determine the likelihood of it happening. Concern about risk should be proportional to the likelihood it will occur. For instance, meteors can theoretically collide with Earth at any time, but it doesn’t make a lot of sense to hide in your basement out of fear of global destruction.
Estimating the probability of risks can be a complicated process filled with complex calculations. Most of us aren’t actuaries, and have difficulty aligning statistical analyses to our personal lives. At the same time, we need to have a process for identifying the risks that would cause the most damage and those that are most likely to occur.
For example, most people don’t like to think about having a debilitating illness or accident that would prevent them from working. But statistically, one in three Canadians have experienced some form of medical condition that caused them to miss work for more than 90 days.
That’s a pretty high probability, and is the type of thing that should be added to the list of risks to manage.
When you know what the risks are, and how likely they are to happen, you can start creating plans to mitigate them. Mitigation can mean preventing the risk from happening, but more often it means reducing the negative impact of things that are beyond our control.
In financial risk management, you can’t control market conditions or political events, but you can make sure your investments are balanced. You can’t control who your parents are, so you can’t control the genes you’ve inherited for certain diseases, but you can buffer the impact of this risk by protecting yourself with proper insurance coverage.
The bottom line is, we don’t have a crystal ball. We can’t see what will happen. And even if we could, we couldn’t stop it from happening. But we can—and should—use common sense to identify, assess and manage risks to ensure we reach our financial goals with minimal bumps along the way.