HOW TO MANAGE PERSONAL FINANCIAL RISKS
HOW TO MANAGE PERSONAL FINANCIAL RISKS
Whatever we do has some element of risk to it. It can be different and different magnitudes. They also come with different probabilities or chances of an unwelcome event happening. If the risks are too low and/or cost too little, we tend to ignore them and not worry about them. However, if the chances are high and/or the costs associated are high, we should be considering options for managing the same.
Types of risk:
As said, there are different types of risks with things we do. Let us explore the ones which are the important ones we worry about and/or are financial.
Personal Risks
Financial Risks
Evaluating the Risks
Managing the Risks
Conclusion
Personal Risks
Risk of physical harm/death:
One risk we face all the time is the personal risk which can take the form of health risks, safety risks, resulting in bodily harm, diseases, disability, and death. This is what we are all worried about especially now. Not only do such events cause emotional distress and personal loss, but they may also result in huge financial costs and losses.
Risk of Financial Loss:
Financial loss can be due to many reasons, loss in business, physical damage/theft to property, valuables, home, etc. Most commonly, it can be due to bad investment decisions or investment strategies. For professionals, it can also arise due to professional liabilities.
Risk of Income:
The loss of income or inability to grow your income is one risk that everyone faces in life. In an age with automation and new skills and job requirements popping up, the challenge remains to stay relevant and upgrade yourself, even if you are in business or a profession.
Risk of Expenses:
Just like the income risk, we also face the risk of expenses. Although we do have some control over our expenses, they can quickly rise without us even realizing it. Changes in your lifestyle, family composition, life events can quickly change your budgets, not to mention any unfortunate events leading to regular medical /treatment expenses.
Financial Risks
Risk of Inflation:
The biggest financial risk we have is unseen and constant. Inflation or the decrease in the value of money with time is the challenge we all face. Unless, we do not gain a return above inflation, after adjusting for tax, we are only reducing our wealth. This understanding is important for all investors.
Risk of Interest Rates:
This is something we are seeing in recent years. The interest rates offered on traditional and government schemes have been on a downtrend. This has left a lot of investors, especially in old age, worrying.
Risk of Liquidity:
The flexibility to any asset or investment to quickly turn into cash easily, without incurring high costs, is what liquidity is all about. For eg., investments in mutual funds or liquid /blue-chip stocks are much more liquid than investments in say government saving schemes or physical gold or real estate.
Credit Risk:
Credit risk broadly means the risk to your capital. Especially when talking about debt instruments, the credit risk is big, and we have credit ratings being published to help us give some indication of the financial standing of the concerned companies /institutions.
Market Risk:
Just last year we saw the equity markets see a sharp contraction after the Covid-19 pandemic spread. We can consider such broad-based market corrections as market risks or ‘systematic risks’ in finance parlance. They can happen from time to time, either due to some financial /political crisis or events like wars, climate, etc.
Specific Risk:
Opposite to market risk is a specific or unsystematic risk where the risk is concentrated on a particular industry or company, etc. These risks are easy to manage through diversification or with quality financial decisions.
Reinvestment Risk:
Say you have a product that pays you 6% and will mature in a year. Here there is a risk since on maturity, there is no guarantee that you will get similar returns if you want to reinvest. After one year, the interest rates may have well fallen below even 6%. This reinvestment risk is common in products with fixed maturities /debt instruments.
Evaluating the Risks
Most of the risks involve financial consequences and as such can be evaluated. There are two elements to risk which need our due consideration – first, the probability of the event, and second, the impact it may have upon our financial situation. However, none of this should be given more weight than required in our decision-making. E.g., if you are overweight the risks of losing some capital in financial markets, you will always avoid equity investments, which would not be a wise thing to do. Not investing in equities in life is a much greater risk which many of us fail to realize.
We also need to be always aware of the extent of a given risk to decide whether to take it on. This is true for every personal risk which we discussed above. We not only need to worry about the probability and the outcomes of risky events, but we also need to weigh them against the benefits of taking on the risk. The reason why this becomes important is that more risky undertakings, involving high-cost outcomes and/or high probability will come at higher costs too. If the compensation is also low but comes at higher costs, then too, a decision on whether taking a risk is more sensible or not is important to decide.
Managing the Risks
Based on our risk evaluation, our choice can be to accept the risk and do nothing else or try to avoid the risk by reducing the probability or potential losses or share /transfer the risk to someone else by getting insurance where possible. Buying adequate Insurance is the most popular strategy to protect against personal risks especially the risk of physical harm /death or financial loss. Insurance works because an insurer can determine the mathematical probability of a risk occurring and the financial risk at stake. With many years of statistics on such events, the insurers can determine the amount of premium necessary to provide benefits to ‘insure’ against any given risk. One can buy insurance to minimize financial loss due to accidents, natural disasters, legal liability, illness, disability, and even death. Money from many people is pooled to pay for losses incurred by a few.
When it comes to financial risks, the most important strategies would be to ‘diversify’, have a proper asset allocation strategy, and have professional management /expert guidance in decision-making. The idea is that your portfolio, asset allocation should be in line with your risk profile and the choice of the asset classes and products is proper in alignment with your risk profile. When planning financial goals /objectives, one further needs to consider the risks of inflation, the risk to your income /expenses, and investments. Experts can help investors to evaluate these risks and make appropriate investments to assure that they will achieve their goals after factoring in these risks.
Conclusion
Managing risk, especially financial risk is very crucial for our well-being. As discussed, there are various ways of managing risks. It is important to identify risks that you face in life and quantify the costs of the same. This is an important first step. Identifying the options of managing that risk and the costs associated with it comes next. Choosing the right approach, the strategy and finally, the right product, if it comes to insurance, is very crucial. We would recommend that you sit with your insurance advisor to clear the entire picture. As an investor, risk management should be considered an important element that you need to learn, understand and manage.
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