Whether you are the CEO of a large corporation, a small business owner or an average Joe who is saving and investing for retirement, when it comes to finances and investments, there are three main tasks you need from a financial group: Risk management, investment management and comprehensive financial planning.
Risk management is a key part of the financial planning process. You may think you’re already doing what you can to avoid losing money. But a closer look at your investment portfolio often shows that you can (and should) be doing more.
For example, do you have a defined strategy for dealing with unexpected events, like a stock market crash or bank failure? You almost definitely have home and auto insurance, but do you have the right health insurance and/or life insurance. These are all examples of risk management.
What Exactly is Risk Management?
Risk management, put simply, is the anticipating and analyzing of financial risks. It also involves formulating a plan to avoid or mitigate adverse consequences, in the event they were to occur. Risk management is understanding and addressing potential risks, then evaluating them to help achieve certain objectives.
In general, there are 4 types of risk:
Pure risk is also known as absolute risk, and is usually insurable. This type of risk has two possible outcomes: Either something – usually bad – will happen, or it won’t. For example, you can buy insurance against your house flooding, and if your house floods, the insurance will cover the damage. If it doesn’t, the insurance company pockets your premium, to cover other future losses.
Speculative risk adds a third possible outcome: Something positive will happen, something negative will happen or nothing will happen at all. The best way to distinguish between pure risk and speculative risk is to look at examples.
Theft and collision are two types of pure risk. Your car will either be stolen, or it won’t. You’ll either be involved in a car accident, or you won’t. There is no gray area when it comes to pure risk. This is why pure risk is an insurable type of risk.
Playing poker or slot machines at a casino, on the other hand, are examples of speculative risk. You might wager $100 and walk away at the end of the night having doubled your money, or you might have lost everything. But there is also the possibility that you break even, gambling all night but still leaving with $100 in your pocket. Investing in the stock market is another example of speculative risk.
Income risk affects your ability to earn or produce income. Some obvious examples of income risk are losing your job, passing away or becoming disabled. Outliving your retirement income is also an example of income risk.
Expense risk simply means that you spend more than you currently have, whether voluntary (buying a more expensive car than you can really afford) or involuntary (incurring medical bills from an unplanned but necessary surgical procedure).
Methods of Risk Management
The most common methods of risk management are avoidance, mitigation, transfer and acceptance.
Risk avoidance is when you avoid high-risk activities, like smoking or gambling, that carry a strong probability of negatively affecting your financial situation.
Risk acceptance is if you consciously decide to personally assume all of the risk in a certain situation, most likely because that makes more financial sense for you. In most cases, it will make more sense to avoid or transfer the risk, but in some circumstances, the cost of accepting the risk may actually be lower than avoiding or transferring it. For example, you might decline to pay for insurance coverage on your cell phone because chances are good that the monthly premiums and deductible will cost more in the long term than paying out of pocket for a replacement phone.
Risk mitigation simply involves minimizing risk and is sometimes known as loss prevention. It lessens the potential impact of a specific unavoidable risk. When it comes to investing, one of the greatest tools for mitigating risk is asset allocation – if you were to put all of your money into one stock and the stock goes down, you’d be in big trouble. But by spreading your money out over different types of investment vehicles, you’re also spreading out the risk.
Risk transfer is protecting yourself. Buying insurance coverage is a perfect example of risk transfer. By paying a premium to an insurance company, you transfer the burden of potential financial risk to that insurance company.
Developing Your Risk Management Plan
Obviously not all risk management methods can be applied to all types of financial risk. However, basic risk management has three defined steps that your financial group should be aware of.
- Establish context and identify/assess possible risks.
- Determine the level of risk you’re willing to take. Which method of risk management best applies to the risk you are evaluating?
- Balance expenditure against risk. Determine the cost of purchasing insurance and whether it makes sense based on the risk and on your financial situation. Although it would be possible to insure yourself against just about anything, the premiums might bankrupt you.
When creating a financial plan, it is wise to discuss your situation with a financial advisor who truly understands risk management.
Why is Risk Management So Important?
Not having adequate risk management procedures in place can be catastrophic. Risk management protects you, your family and your finances against the unexpected. In the financial world, risk is inevitable, and sometimes it is even necessary for gains: You can’t make money in the stock market if you don’t take a chance and invest in a stock that you believe will perform well.
It’s important to identify your goals and priorities, but also to know and measure the possible risks associated with them. Your financial situation can be impacted by any number of unforeseen things, and establishing realistic risk management procedures can help protect you against many of them.
Because risk management is such a broad topic with many variables, and because it is such a specific, lengthy process unique to each individual, you may want to work with a financial group to develop your risk management plan. A financial advisor can help you define procedures to analyze and prepare for financial risks based on your particular circumstances and regularly re-evaluate your strategy to help ensure it continuously aligns with your financial needs and goals.
Risk management is an important step that should not be skipped when creating a comprehensive financial plan. If you’re looking for a financial group to help you in this process, contact us and schedule up a free, no-strings-attached initial conversation. It’s our goal to help investors; not push products that aren’t in their best interests.
This material is provided by PAX Financial Group, LLC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The information herein has been derived from sources believed to be accurate. Please note: Investing involves risk, and past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All market indices discussed are unmanaged and are not illustrative of any particular investment. Indices do not incur management fees, costs and expenses, and cannot be invested into directly. All economic and performance data is historical and not indicative of future results.