Dear S&B, I hear the term, “risk management” in the context of financial planning, but
what does that mean? Jeremy – Santa Barbara
Life is full of risks but the key is to identify them ahead of time and make decisions on how you want to address them. While “Risk Management” in the context of financial planning is a rather broad term, we think it is best to view it as two categories; controllable and non-controllable.
For example, you can decide if you want to invest in the stock market or not, a controllable action. However, lawsuits arising from a car accident, an unexpected change in personal health, a natural disaster are examples of “non-controllable” events. The most common non-controllable items often pertain to inflation, taxes and the economy. Whenever dealing with risks, we view four routes you can take.
Assume the Risk: This is pretty self explanatory but is the outcome both measureable and acceptable? For instance, if you make a risky investment, your maximum risk exposure is typically 100% of what you put in. However, if you become disabled, not only are your future earnings capabilities at risk, the cost of health care can fall into an extremely wide spectrum.
Whenever considering risks, we find it helpful to recognize the Probability and the Magnitude of such events. For instance, the magnitude of a meteor hitting the earth and ceasing life is colossal but the probability is infinitely small. It is usually most prudent to address the higher probability items first when it comes to planning.
Avoid the Risk: Life is full of risks and generally rewards are reaped long term for assuming some level of it. Avoiding them altogether is unrealistic and can adversely impact “quality of life” either today or most likely in the future. Additionally, “avoiding” risk altogether actually can create them. For example, take someone who retired in the early 1990′s and placed all their retirement money in “safe” cash investments, while inflation has continued to roll along. This sort of risk avoidance can create unwanted problems down the road.
Shift the Risk: This usually comes in the form of purchasing insurance. A check we never want to write yet one of the “wisest decisions” ever made if something goes wrong. In many cases, insurance is the most cost effective way to address risk. You can also gauge the probability of payout by the costs being charged. If insurance is really cheap, the likelihood they put on the claim is probably small. But if it is “expensive,” that is a good indication that risk may be higher than you perceive.
Ignore the Risk: We would not say this is the “preferred” way to go. Addressing the “unknown” can be liberating. You know it exists so dealing with it and making an informed decision on how to address your needs is far better than pretending it won’t ever happen to you. Years of great investing and saving can all be put in jeopardy by improper planning. And this does not have to be just an “insurance” issue.
Investment risk lessons abound. In the 1990′s people concentrated their money in specific investments (such as their company stock or just a few “high octane” mutual funds) only to have it significantly reduced in value because they ignored the risks associated with their “nest egg.” We saw it again most recently with real estate. Some other potential “bubbles” currently seem likely but only obvious once they burst.
From a wealth management perspective, we recommend you focus on your individual and family goals so that you can start to identify the true “risks” that are specific to you. When it comes to investments, diversified portfolios that match your risk tolerance level while also addressing your short and long term goals are usually most prudent. Finally, put a tax management plan in place that is unique to your specific situation.
Start with your “foundation” of high probability risks and work up from there. The lower magnitude risks you may want to assume but others not so much. You will be surprised by how effective and psychologically liberating it can be. Not to mention how it can help you and your family accomplish and protect a lifetime of work.
If you have any questions you want addressed, please submit them to firstname.lastname@example.org.
Author’s Note: Brad Stark, MS, CFP, AAMS, CMFC and Seth Streeter, MS, CFP are Co-Founders of Mission Wealth Management, LLC, a Registered Investment Advisor. The information contained in this article is general in nature and should not be construed as comprehensive financial, tax, or legal advice. As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action. Securities offered through National Planning Corporation, Member FINRA/SIPC. NPC and MWM are separate and unrelated entities. Certain statements contained within may be forward-looking statements, including but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties; all statements are subject to change without notice. Also, historical performance cannot predict future results.