The following is adapted from Keep It Simple, Make It Big.
Everything in life carries risk, and investing is no exception. Even if you take no nominal risk with your money—you stuff $100 bills into a nuclear-war-proof safe in your basement—you are still subject to one of the most pernicious risks: the loss of purchasing power of money through inflation.
Financial risk can never be completely eliminated, so you must instead find ways to manage it. Managing your risk is the key to enjoying a life and retirement free of financial worry.
In general, risk can be addressed in four ways. The options available will depend on the nature of the risk, its likelihood, and likely financial consequences. Which option, or combination of options, you select is a personal choice. It will, however, impact those who depend on you.
#1: Avoid Certain Behaviors
The first way to address financial risks is to avoid certain behaviors.
Consider the risk of dying or being disabled in a motorcycle accident. A way to avoid that risk is to simply not ride a motorcycle.
With your finances, you cannot try to avoid all risks. That would require utilizing only “safe” investing or saving methods, and the problem with these methods is that they do not come with a high enough interest rate to match inflation. While you technically wouldn’t lose any money, you would lose a significant amount of purchasing power.
That said, there are certain behaviors you should avoid to minimize your financial risks.
First, don’t engage in speculation. Speculation is high-risk and is akin to gambling. There’s potential for big wins, but also potential for catastrophic losses.
Second, don’t concentrate your wealth into a single stock. Concentration of company stock in a 401(k) plan is an all-too-common mistake. At Enron, a famous corporate blowup in 2001, 62 percent of the assets in employee self-directed 401(k) accounts was Enron stock. When Enron’s stock became worthless, so did 62 percent of the account balances in Enron employees’ 401(k)s.
Enron was not the first company stock calamity and it won’t be the last. A stock doesn’t have to become worthless to punish overconcentrated investors. A sharp decline in value can have big ramifications, so avoid putting too much of your wealth in company stock.
#2: Adjust to Minimize Consequences
Your next risk-management strategy is to adjust to minimize consequences. In the motorcycle example, this would be wearing a helmet, gloves, and leathers, and not driving in poor weather.
The best way to minimize the consequences of financial risks is diversification.
You should diversify in two ways: (1) allocate investments over many asset classes and (2) diversify investments within asset classes.
Diversifying across asset classes means that you don’t put all of your money in, say, the stock market. Rather, you put some money in stocks, some in bonds, some in a life insurance policy, some in an HSA, and so on.
Different asset classes react differently to economic changes, so by allocating investments over many different asset classes, you can help insulate yourself from market downturns. During the 2008 financial collapse, for example, those investors who had allocated some assets to US government bonds did better in comparison to those who were only invested in the stock market.
Diversifying investments within asset classes is also important to managing risk. If you are invested in only a single stock, for example, and something goes wrong, the consequences will be disastrous. With your money spread out across many stocks, a single stock’s decline won’t affect you as much.
It’s important to not only diversify in number but type. For instance, in the dot-com collapse in early 2000s, if you had fifty different stocks but they were all technology companies, you were in trouble. In contrast, investors who were allocated to other kinds of stocks, like foreign stocks, did not suffer as much loss in value.
#3: Transfer Risks to a Third Party
Your third option is to transfer risks to a third party. In the motorcycle example, this would be purchasing life, disability, motorcycle, and liability insurance.
It’s a good idea to transfer risks to a third party when a risk is unlikely but would have severe consequences if it were to occur. For example, a 30-year-old person is not likely to die, but if this person is the breadwinner for a family, the consequence of his passing might have catastrophic consequences for those he loves. Therefore, it’s wise for him to have life insurance.
We use insurance to prevent physical and human tragedies from becoming financial tragedies. This category of risk management includes all the various insurance policies that protect you from the financial costs of unexpected events—health insurance, life insurance, disability insurance, homeowners’ insurance, car insurance, and so on.
With this method, it’s important to note that risk must be transferred before it is imminent. In general, once insurance is needed, it cannot be purchased at a reasonable cost, if at all. So get insurance early, before you need it.
#4: Retain Risk
Your final risk management strategy is to retain risk, being prepared to accept the consequences. For example, in the motorcycle example, even with insurance and the proper equipment, if you’re injured, you will have to deal with some consequences, including insurance deductibles and copays.
You should retain risk in cases where a risk is unlikely and of little consequence, such as a dorm-room refrigerator breaking down.
In deciding which risks to retain, you need to be honest with yourself. Just because you can retain a risk doesn’t mean it’s a good idea.
A few years back, I was listening to a popular personal finance radio show, and a woman called about a neighbor’s tree that had crushed her house in a storm. It was considered an act of God, so it was her responsibility, not her neighbor’s.
The host told her to contact her insurer, and it would pay the bill. The caller, however, was out of luck. She’d paid off her house and cancelled her homeowner’s insurance to save money. Big mistake.
A frugal mentality can cost you more money in the long run, so be thoughtful about the risks you choose to retain.
Manage Your Risk
“We know only two things about the future,” says Peter Drucker. “It cannot be known, and it will be different from what exists now and from what we now expect.”
You cannot predict the future, so you cannot totally avoid life’s risks. But you can—and must—manage them.
With a combination of all four of these strategies, you can better prepare for the risks of life and ensure they don’t turn into financial catastrophes.
For more advice on managing financial risks, you can find Keep It Simple, Make It Big on Amazon.
Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.
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