Life is full of risks and we all adopt active or passive approaches to manage the risks that we face, even if we may not realize it. In this article, we will examine the types of risks we face and the different methods we can use to manage them. We are restricting the types of risks to personal financial risks i.e. we are not addressing business or commercial risks.
A financial risk exists if we face a potentially unfavourable impact on our personal finances if a particular event or a situation takes place. This unfavourable impact could be that we lose money, we are forced to incur unexpected expenses that threaten our financial security, or we face considerable stress because of the financial uncertainty.
Risk Management Basics
There are two broad approaches to managing risks:
This is where risk is transferred to a third party (usually an insurance company), and you pay the third party for accepting the risk. Not every risk is transferrable, but while several indeed can be transferred, it is too expensive for the average person to pay to transfer all possible risks.
We will cover using insurance to manage personal financial risks in more detail in Using Insurance to Reduce Personal Financial Risks – Part 1 and Part 2.
The second broad approach is to assume the risk personally, which means you accept the responsibility for any potential outcome. Your accepting the risk could occur either “by force” because there is no third party to transfer the risk to, or although the risk is transferrable, you deliberately decide to “self-insure”. We’ll return to the concept of self-insuring in Using Insurance to Reduce Personal Financial Risks – Part 1.
When you decide or are forced to assume risk, you instinctively try to manage it in three possible ways:
- Avoid: People can avoid risks associated with, for example, ill health by not smoking.
- Reduce: For instance you can reduce the risk of theft of your household property by burglar proofing your home, or reduce the risk of damage to your home from fire by installing smoke detectors.
- Prepare: As it is impossible to avoid or reduce all risks to zero likelihood, you then manage the residual risk by preparing for an adverse financial impact.
Let’s now focus on specific personal financial risks and examine some approaches you can use.
Overspending refers to two situations: spending in an uncontrolled fashion, and secondly, spending more than you earn. The financial risk associated with overspending should be fairly obvious. In the first instance, you are not in control; therefore, any savings you make is purely an accident. In the second case, if you spend more than you earn, your only choice to fund the shortfall is to incur debt (other than selling something you own). But as many of us come to learn, adding debt in an unmanaged fashion is a recipe for future financial hardship.
(Learn more in The Debt Decision.)
It is impossible to be in control of your money unless you know exactly how much you earn (and more importantly) how much you spend. The only tried and tested way to achieve this is to live by a budget and regularly track your actual income and expenses against what you budgeted. When you prepare a budget, it forces you to have in depth knowledge of yourself and make conscious decisions about your lifestyle and savings targets.
Too much debt
A high level of debt reduces your overall financial flexibility because (very likely) most of your assets would be pledged to secure the loan(s), and your monthly debt payments would be consuming most of your income. Having an elevated level of loan repayments also leaves you vulnerable to changes in your income and expenses i.e. small changes could lead to your being unable to both service your debt and meet your living expenses. The emotional aspect also should not be underestimated: a mountain of debt creates a mountain of stress.
The simple approach to avoid this risk is to know how much debt you can service comfortably. Many people, however, are unable to properly assess this themselves. The reality is your budget should be your guide. For example, if you use our Cari$ Sample Budget, you’ll notice that we arranged the expenses section of the budget into Fixed (broadly these are your needs) and Discretionary expenses (broadly these are your wants). Fixed expenses are those that you cannot easily reduce in the short-term, which includes your loan payments.
We recommend you set a target for how much of your after-tax income you wish to save, and consequently, allocate the rest to how much your wish to spend on Fixed and Discretionary expenses. In this way, you can assess if current or proposed loan repayments can be accommodated within your targets. If your targets are being exceeded, you can immediately form a plan to bring it back into line over time.
Variability of income or Unexpected expenses
A common risk that some face is income that could change each month (e.g. daily paid workers or persons working on commissions or sales incentives). But even persons with stable incomes could sometimes be faced with unexpected expenses. We often think of our expenses as regular monthly amounts (e.g. rent, mortgage payments, or most utilities) or predictable annual amounts (e.g. car or house insurance, subscriptions, or credit card annual fees). While it is fairly easy to include these items in your budget, we are often faced with unexpected expenses that are more difficult to budget for e.g. broken spectacles, minor car accidents, appliance repairs, or calls to your plumber and electrician.
There are three approaches to manage these situations. The first and easiest to put in place is an Emergency Fund. This is simply money set aside to cover an unforeseen event or emergency. The usual benchmark for the size of the fund is 3 to 6 months of expenses, although this would vary depending on individual circumstances. Note, this is not part of your savings: its purpose is to cover future unforeseen expenses.
Two other approaches, although less easy to implement, are firstly, try to maintain a low level of Fixed expenses, and secondly, try to develop an additional income stream. A low level of Fixed expenses means a smaller proportion of your income is being applied to expenses that you cannot easily change. A low level of Fixed expenses implies having a greater proportion of Discretionary expenses, which gives you considerable flexibility to reduce these when the need arises. The benefits of having a second income should be relatively straightforward to understand.
A destabilizing financial event takes on much greater significance when we have dependents (spouse, children, etc.) than when we are on our own. The simplest and most frequent example being a family where both spouses are required to work to support their young children. If one spouse were to die suddenly, the surviving spouse and children would struggle to make ends meet on one income.
This situation is best handled by both spouses buying life insurance. In the event of death of one spouse, the insurance proceeds could be used to repay loans, earn income, or pay for children’s education.
Loss of income
Loss of income could arise in several ways: ill health, disability (where you are unable to pursue your regular or any work due to injury or illness), or due to death.
The risk of income loss is particularly significant when you have dependents, but it is also important even if you have no dependents because you still need to provide for yourself.
Protection from the resulting loss of income is generally provided by buying insurance. Additionally, it should be acknowledged that the incidence of sickness could be reduced by following healthy habits and lifestyles – actions that are within our control.
Loss of assets
We can face risk of loss of assets in two forms: (a) damage to physical assets such as homes or cars or loss due to burglary or (b) loss from financial investments (i.e. we lose the capital invested).
Physical assets can be protected from damage or burglary using insurance. There are many options and levels of coverage to fit most budgets.
Loss from financial investments could occur for numerous reasons and the purpose of this article is not to discuss investing principles or the trade off between risk and return. For our particular focus the two actions we can take to minimize risk from loss is firstly, diversify where you put your money i.e. follow the old adage: “do not put all your eggs in one basket”. Secondly, do not put your money in an investment you cannot understand.
Inadequate retirement income
In a way, this point is an extension of the risk of loss of income. When we grow older, our ability to work decreases, and consequently our ability to earn income decreases. As we enter this phase of life, we retire from active work. Many persons also choose to retire early enough so they can enjoy, in relatively good health, aspects of life that were not possible during their full time employment.
To have a financially secure and stress free retirement, you need to have a reasonable pool of capital to use to meet expenses. This pool is accumulated during your working life, and the obvious personal financial risk is not having set aside sufficient funds. Related to this is the risk that inflation could erode the purchasing power of your savings over time.
The simple response to these risks is to save as much as you can, as early as you can. Having a budget and following our 33/33/33 approach provides the framework for retirement savings.
In addition, for those earning primarily salaried income, managing your career continuously upward is the major way you can obtain higher income (and hopefully save more), or even prepare yourself by being marketable if you are faced with loss of income from redundancies, terminations, or voluntary departures.
(Learn more in Career Management: Essential for Financial Security.)
Certain insurance products also address the needs of individuals who need income in retirement.
As you can see, we face several personal financial risks, but there are many approaches to minimize or prepare for the risks that we face. Take a few moments and consider which of the risks you face personally and then try to apply the approaches we suggest. It will set you on the right path toward financial peace of mind.
As mentioned in the introduction, we’ll take a greater look at the role insurance can play in managing certain risks in Using Insurance to Reduce Personal Financial Risks – Part 1 and Part 2. Stay tuned!
We hope you enjoyed reading, and we’d love to hear from you in the comments below if you have questions or experiences to share!