Why Risk Management is Important
Risk Management is a term most frequently associated with large businesses due to its crucial importance for corporations. However, risk management activities are just as vital when it comes to personal finances. By definition, risk management is the process of understanding, analyzing and addressing potential risks to ensure objectives are achieved. Sounds simple enough, but why is it so important and what steps can you take in both business and personal finance to mitigate risk? Let’s first take a more in-depth look at what constitutes risk management.
What is Considered Risk Management?
We know based on the definition of risk management that it is the methodology used to mitigate adverse consequences that result from threats and uncertainties. Put simply, this means developing a strategy to avoid losing money when unexpected events occur. In corporate finance, this could be a succession plan that would be put into effect when a key stakeholder of the company is no longer able to perform their duties. In personal finance, however, there are many different situations which could result in financial hardships that you will want to plan for. This planning process is risk management. The primary goal of personal risk management is to protect one’s goals, dreams, treasure and personal well-being from the “what ifs” in life.
Generally speaking, there are four types of risk, but they are not all mutually exclusive. The first distinction is pure versus speculative risk, and a single event can be one or the other when it comes to these labels, not both. Pure risk is a loss that is only possible if an event actually occurs. For example, your house will either flood or it won’t, there is no in between. Pure risk is often insurable. Speculative risk, on the other hand, can result in a gain, loss, or no change at all. An excellent example of this is gambling. And while you can hedge against these risks (more on that later), they are not generally insurable.
Risk can also be defined as either income risk or expense risk. Just as the name implies, income risk affects your ability to produce an income. Specific examples of income risk include death, loss of work, underemployment, becoming disabled resulting in an inability to work, and, for retirees, outliving your income producing assets.
Expense risk is slightly more complicated but is essentially the idea that you will spend more money than you currently have. This can be voluntary or involuntary. For example, voluntary expense risk would be spending more money than you earn while involuntary expense risk occurs when an emergency forces you to spend money. Often times, an income risk could lead to an expense risk. You may also not be earning enough money to meet your needs, a marker of poverty.
The Risk Management Process
There are different methods of risk management for the various types of risk; however, the process generally has three specific steps:
- Identify the cause and nature of the risk. To use one of our previous examples, your death would leave your family to cope with the lack of income to pay debts and living expenses.
- Determine how much risk you are willing to retain. This could be how much deductible you are willing to assume for an insurance policy. Or it could be your choice of a living location and the associated natural disasters of the area. Generally speaking, we all assume some sort of risk every day, it is unavoidable.
- Determine how to handle risk not retained. An important risk management factor is the balancing of insurance expenditures against the risks which present the most significant negative impact on your individual personal financial plan. In theory, we could insure ourselves against almost any risk but go broke paying the premiums.
This process should be followed for any risk you want to plan for, and the list of possibilities is nearly endless. As a result, it is important to identify your priorities alongside the risks most likely to come to fruition. This means every individual’s risk management plan will be as unique as their fingerprint. It is also crucial to know that risk management is never a stagnant process, you can’t just set it and forget. You should be reviewing your risk management strategy regularly and assessing whether or not it still satisfies your current needs and objectives.
Methods of Risk Management
By employing risk management strategies, we are better equipped to address unpredictable scenarios that can wreak havoc on our personal finances. Risk is not necessarily a bad thing, so long as it is controlled. There are a number of strategies you can use to manage your specific risks. All things considered, there are five distinct strategies when it comes to risk management:
- Risk Avoidance This entails attempting to avoid high-risk activities which could result in catastrophic impacts on your personal finances. Speeding, extreme sports, or smoking are all examples of high-risk activities.
- Risk Retention In this method, you personally assume all the risk and choose not to mitigate the risk at all. For example, forgoing long-term care insurance because you believe you have enough assets and income to cover the costs should the need arise.
- Risk Reduction Also known as loss prevention and control, this involves minimizing risk. You can do so by using an insurance company that uses the law of large numbers to maintain their solvency, for example, or by installing smoke alarms in your home.
- Risk Sharing In this strategy you assume a limited degree of manageable risk and transfer the balance of the risk to one or more organizations. Paying for medical insurance is a perfect example of risk sharing.
- Risk Transfer As it sounds, in this strategy you completely transfer risk to a third party in consideration of an insurance premium. Life, disability, and liability risks are often dealt with in this way.
There are also a few things you can do outside of the formal strategies listed above to help create and enforce your risk management strategy.
- Know Yourself It is crucial to understand your risk profile and capitalize on your strengths can increase your chances of success. Without this introspection, you are setting yourself, and your risk management strategy, to fail.
- Stay Competitive Keep your employment skills up-to-date and on the cutting edge. You never know when you might need to apply for a new role.
- Carry the Right Insurance Identify the types of insurance that will be important to you (medical, automobile, short-term disability, etc. and find a plan with a manageable premium. It can be nice to know you have a little safety net if things suddenly go wrong.
- Build an Emergency Fund It is generally accepted that you should have a small savings fund which could cover about three to six months of living expenses. This will help mitigate the risk of loss of work which could occur for many different reasons.
- Diversify Investments By investing in various markets, you can ride out any short-term changes in any singular marketplace. As they say, don’t put all your eggs in one basket.
- Limit Debt Be careful of how much you spend on credit cards and think carefully before taking on any loans. What can start as a temporary fix could quickly spiral out of control and result in expense risks.
- Stay Healthy One of the most common causes of personal bankruptcy is ill health due to the large medical bills associated with the care of diseases. Take the time and spend the energy to keep yourself healthy – it will pay off in the long run.
- Do Your Due Diligence When you make any sort of financial decision, big or small, be sure to read the fine print and truly understand what you are committing to.
Why Risk Management is Important
Hopefully, by now you have developed an innate understanding of why financial risk management is important for the sake of your personal finances. However, if you need a few more reasons laid out, here they are:
- Risk management helps you prepare for the unexpected. While we cannot plan for everything that will happen to us, we can try to minimize the effects felt by such circumstances.
- It can protect your family. Should anything happen to you; such as death, unemployment, medical accident or disease; your family will be taken care of and not left with extreme debts or financial hardships.
- It protects your financial status. Similar to the last, your financial status will be safer if you have a plan in place to handle unexpected situations. Many circumstances can impact your finances and risk management will help you ride out those changes.
As you can see, risk management can give you peace of mind and allow you to weather the proverbial storms with a controlled amount of damage.
The above can also illuminate why risk management is important for business as well. In a corporate environment, risk management strategies help to protect the company as a whole as well as employees from unexpected financial impacts. Just as in personal finance, preparing for specific scenarios helps a business to withstand any hardships that may come their way and allow them to come out the other side.
Hopefully, at this point, you understand and have taken to heart just how important risk management actually is. If so, the next step is to develop your risk management plan for your investment portfolio. While it is possible to accomplish this on your own, it is a lengthy process with multiple factors and some people may find it useful to work with a financial advisor to help create not only their risk management strategy but an overarching financial plan as well. Pure Financial is here to help with your financial needs, whatever they may be! Our portfolio of services and quality advisors would love to help you reach your financial goals as a means of achieving your dreams. Speak with an advisor, today!