“Risk comes from not knowing what you are doing.” — Warren Buffett
People who are confident with money understand financial risk. The first thing to know is that risk is not a negative concept. Without risk, we could never do anything different from what we have done in the past. Many of the greats in business, sports, and entertainment took risks to become the “greats” they are. However, risk also brings with it a varying probability of negative outcomes. Our job is not to eliminate risk, which is impossible, but to find the sweet spot between the benefits risk provides vs the higher probability of a negative outcome.
Risk could result in financial disaster if we don’t understand it. According to the TIAA Institute and the Global Financial Literacy Excellence Center (GFLEC) at the George Washington University School of Business, we are not very good at recognizing financial risks. This study (2021) demonstrated most of us fail to comprehend common financial risks, with only a dismal 37% pass rate among Americans surveyed.
Here are the strategies we utilize to manage risks:
Accept risk and the possibility of loss as it is.
Avoid risk.
Reduce risk.
Share risk to lessen its impact on one individual.
Transfer risk.
You choose which strategies work best to reduce your financial risk for your personal situation and environmental circumstances.
We apply each risk management strategy to our three board financial risk categories:
Income
Budgeting
Investing
Common income risks include events such as job loss, economy-wide inflation, or an injury that creates a disability leaving you unable to earn income. You can reduce these risks by creating multiple income streams, saving money in case of a job loss, and by following the job’s safety rules to prevent injury or death. You might also reduce income risk by securing a stable job and keeping your job skills current so you might easily find another job in case of employment loss. You can share this risk with your partner by creating multiple income streams. You might also transfer some of the risk through the purchase of disability or life insurance.
Budgeting risk occurs most often when we fail to budget! A lack of budgeting results in little or no savings and the overuse of credit. Utilizing too much of your income to pay your bills places you at the edge of your income’s capacity to pay monthly bills. When something goes wrong, this will put you in dire straits when you have to pay unexpected expenses. The number-one strategy to avoid this risk is by completing and following a budget. You can also reduce poor budget outcome risks by creating savings. Another budgeting risk is inaccurate budget predictions regarding your income and expenses. Reduce this risk by tracking your income and expenses over time to create accurate future predictions.
Investing risk occurs when events negatively impact your investments. Here are the more common risk categories for your investments:
Systematic risk is the risk of economy-wide downturn.
Unsystematic risk is the downturn of a single industry or individual company.
Market timing risk means buying when the financial markets are high, reducing your profit in the short term.
Interest rate risk is the risk that interest rates will rise, which will negatively impact some stock investments and also impact bond prices you already own.
Inflation risk is the risk that lower dollar value will negatively impact the value of the income your
Country-specific risk is the risk certain countries will have an economic downturn or pass new regulations that negatively impact your investment there (regulatory risk).
Investing Risk Reduction Strategies:
Utilization of modern portfolio theory creates diversification and reduces risks across the board. When one group of investments are doing badly, other groups are typically doing better. Diversification, therefore, helps protect you against sudden financial market drops in specific companies, sectors, and industries.
Dollar cost average (contributing to investment accounts over time) reduces the risk of financial markets being either up or down when you buy into your investments. Long-term investing reduces the short-term profit and loss swings caused by volatility (large market swings up and down) and timing. It creates greater opportunity for profits as most financial markets rise in price over time.
Mutual funds can (depending upon the type you own) reduce your risk through broad diversity. We own multiple index mutual funds and work hard to keep the overlap of individual investments in these funds to a minimum.
This primer will allow you to better understand and recognize the many financial risks we all face.
~ Larry Faulkner
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