Written by: Corey Janoff
An important aspect of financial planning is risk management. How we manage the financial risks that could affect us could mean the difference between achieving financial independence or not. When planning for your financial goals, consider what risks could hinder your ability to achieve those goals? What can you do to either mitigate them? Today we will discuss what financial risk is, why it arises, and how managing risks can impact your financial future.
What is Financial Risk?
In short, financial risk is anything that could adversely impact your finances or hinder your ability to achieve your financial goals. People might most commonly think of the effect of their 401k or other investments going down in value. While that is one financial risk, there are many others as well that could get you. Let’s start by looking at some of the main risks that could impact most people’s finances and what that could mean for them.
Investments go down in value. This can delay the time it takes to achieve your goals, reduce your spending power in retirement, etc.
Medical expenses. Depending on your insurance plan, you could be on the hook for tens of thousands of dollars.
Costly home repairs or other unexpected expenses.
Death. If you or your spouse dies, that could mean less income or additional childcare expenses.
Disability. If you can’t work anymore, no more income. Additionally, if it’s a severe disability needing assistance with daily living, it will drastically increase your living expenses.
Job loss or pay cut. We saw this year many people who thought they had stable jobs were laid off or forced to take pay cuts. Obviously, the reduction in income will impact household finances.
Natural disasters, theft, housefire, etc. Things that could cause damage to, or loss of, your property.
Lawsuit. If it’s a work-related lawsuit, you likely have malpractice insurance to cover that. However, there could still be some out of pocket legal bills. If it’s a personal liability, it could be a very costly lawsuit.
Divorce. Cutting the household assets in half sets you back.
You might think of some others, but these encompass most of the risks facing people.
Best Ways to Mitigate Risk
Some of these risks can likely be mitigated with proper insurances.
You could purchase disability and life insurance to provide a benefit if you pass away or incur a disability and are unable to work. Most people have home & auto insurance if they own a home or drive a car. Umbrella liability insurance provides additional protection on top of home & auto policies and other personal liabilities: flood, fire, earthquake insurance.
Other risks require a bit more planning. The unexpected expenses are easily prepared by having a sufficient emergency reserve fund. Easier said than done, of course. A healthy emergency reserve fund can help you prepare for a lot of risks. Most financial advisors recommend 3-6 months of living expenses saved up for emergencies. This should cover most unexpected household or car repairs. Also, if you are out of work for several months, it gives you money to live on while you presumably don’t have income.
A healthy emergency reserve helps with the decrease of income in the event of a job loss or pay cut as well. The larger the reserve, the longer you can weather the storm.
Living below your means is arguably the best way to prepare for emergencies. It essentially reduces the impact of all possible risks. If we have more money coming in than going out, that gives us a lot of flexibility. We can survive the pay cut. We can recover from unexpected expenses. We can afford to carry less insurance, further reducing our monthly expenses. Not relying on 100% of your income allows you to take the occasional blow and bounce back.
Lastly, saving for the sake of saving can help reduce the impact of financial risk. If your investments go down in value, but you have been investing more money than you need to, the investment loss won’t impact you as much as someone who hasn’t saved as much. Coupled with living below your means and having a sufficient emergency reserve really give you a big cushion when it comes to financial risk.
Importance of Planning
Planning for these risks is smart. Get the proper insurances. Have an estate plan, so your money and kids are taken care of according to your wishes if you pass away. Calculate how much emergency reserve is adequate. Estimate how much you need to invest regularly to achieve your goals and give yourself enough buffer if things don’t go as planned.
Things happen. Investments don’t perform as well as expected. Design a plan to still work even with a lower-than-expected investment rate of return.
Expenses may higher than anticipated. Kids move back in with you as adults. Incidental costs pop up from time to time. Be prepared to take on those additional costs, even if you may never need to.
The Biggest Risk of All
The most significant risk you face is the one you don’t see coming and can’t plan for. If you can predict the risk, you can prepare for it. You can do all the risk preparation in the world, but nobody saw COVID-19 coming. Nobody predicted that a booming economy would come to a screeching halt, wipe out 20% of the workforce for the foreseeable future, and cause employers and workers to adapt to a new way of doing things.
That’s where having proper savings and adequate flexibility within your budget and financial strategy is crucial. It prepares you for things you can’t prepare for.
Being able to achieve your financial goals is all that really matters when it comes to financial planning. Therefore, I supposed the biggest risk of all is not being able to achieve your goals. If that happens, then what?
Save more than you need to. Buy the right insurances. Live below your means. Maintain the proper emergency reserve. Make it so you don’t need everything to go perfectly to achieve your goals.