What Are the Elements of Financial Risk?
And How Does Financial Planning Help With Financial Risk Management?
By Marc Usem
What’s Included:
• Understanding financial risk
• Common types of financial risk
• The three dimensions of financial risk
• Assessing how much financial risk you can take on
• The impact of risk on financial planning
• Financial planning as a risk management tool
• Next steps for managing financial risk
”Luck and risk are siblings. They are both the reality that every outcome in life is guided by forces other than individual effort.” – Morgan Housel, The Psychology of Money
Like it or not, risk is a part of life. In order to eliminate risk, you would need to be able to control every possible factor affecting every possible outcome. A task we can all agree is unrealistic.
But, that doesn’t mean that we live entirely at risk’s mercy. Nor do we mindlessly follow a random trajectory through life. We make decisions every day that affect what type and how much risk we are exposed to. Risk is a particularly important factor in financial planning, because of how many different types of potential financial risks there are.
Luckily, there are many ways to address the elements of financial risk through risk management.
What Is Financial Risk?
Risk comes in many forms and from many different sources. When thinking of financial risks, you probably think of the unpredictable nature of stock market returns. But, there are also behavioral risks, such as buying due to the fear of missing out (FOMO) or selling due to panic. There are also physical risks, such as living longer or shorter than you had planned.
What Types Of Financial Risks Are There?
Below are some of the types of risk that may be encountered as part of your financial planning process:
- Market losses
- Not meeting financial goals
- Sequence of returns - the risk that poor returns may happen when you need money, such as during retirement
- Financial stress/not sleeping well
- Poor health or death
- Not taking action (taking action)
- Longevity (long or short)
- Risky behaviors (FOMO, panic, etc.)
- Psychological biases
- Trying to the time the market
What Are The Three Dimensions Of Financial Risk?
There are three primary dimensions to consider when determining the right amount of risk for your investment portfolio or financial plan: risk tolerance, risk capacity, and risk composure.
Risk Tolerance - How much risk are you comfortable taking
Risk tolerance is an emotion-based dimension that attempts to gauge how much risk you can handle, while still being able to sleep soundly at night.
Risk Capacity - How much risk you are able to reasonably take
Risk capacity attempts to measure how much you can afford to lose, or would not need to gain, while still staying on track toward your overall financial goals.
Risk Composure - How you might respond to risk based on a financial situation or condition
Risk composure is a behavior-based dimension that attempts to describe how you might behave differently if faced with a more significant financial event, such as a large loss or outsized gain.
How Much Financial Risk Can I Take On?
In order to accurately determine how much risk to take on in your financial plan, you need to consider all three dimensions of risk. Looking at just one, or even two, of the dimensions without the others may give an incomplete picture.
For example, you may have a very high risk capacity, meaning you could take on a high degree of risk and still have a strong probability of reaching your financial goals. But, if your risk tolerance is low, and the thought of even small financial losses keeps you up at night, a financial plan with significant risk would not be the right fit for you.
Alternately, you may determine that you have a high risk capacity and are not emotionally bothered by the threat of high market volatility, and that you have a high risk composure and are unlikely to abandon your investment strategy based on a significant financial event. But if you have a low risk capacity, meaning that a financial loss could derail your financial goals, it is important to make risk management a key component of your comprehensive financial plan.
How Do Different Types Of Risks Affect Financial Planning?
Risk is an inevitable part of life. But that doesn’t mean that you have no control over it. In fact, some types of risk are entirely in your control. It is important to be aware of and take advantage of the risks you can control, such as financial planning, portfolio diversification, and your investment asset allocation. Even risks you can somewhat control, such as health and behavior, and risks you can’t control, such as market losses or longevity, can benefit from risk management through solid financial planning.
Risks You Can’t Control
- Market volatility and losses
- Sequence of returns
- Longevity
Risks You Have Some Control Over
- Health
- Financial stress/not sleeping well
- Psychological biases
- Risky behaviors (FOMO, panic, etc.)
Risks You Can Control
- Financial planning - taking action or not taking action
- Portfolio diversification
- Investment asset allocation
How Does Financial Planning Help With Risk Management?
Risk management is a key component to a comprehensive financial plan. A financial plan takes the three dimensions of risk - risk capacity, risk tolerance, and risk composure - into account in order to address the three types of risk - risks you can’t control, risks you have some control over, and risks you can control. A good financial plan will proactively safeguard your finances in order to keep you on track to reaching your financial goals.
A financial planner can guide you through the various risk factors that can affect your financial plan. They help ensure that your financial plan contains the right amount of risk for your personal situation. A financial planner will help ensure that you have taken steps to address those risks that are totally or somewhat within your control, and that you have a comprehensive risk management plan to address the risks you can’t control. This includes designing a globally diversified investment portfolio, ensuring you have a good place to access cash during a market downturn, guiding the creation of an insurance portfolio that suits your specific needs, and acting as a “coach” to help you avoid behavioral risks.
Financial Planners provide financial risk management by:
Portfolio Macro Asset Allocation
Financial planners can help reduce market risk by creating investment portfolios that include a mix of stocks, bonds, alternatives, and cash. This type of macro asset diversification protects investors during times of market volatility.
Portfolio Global Diversification
Similarly, working with a financial planner can help reduce market risk by creating globally-diverse portfolios. This type of diversification protects investors by spreading their investments over a mix of U.S., international, and emerging markets stocks, rather than being concentrated in any one specific segment.
Good Places to Get Money
Financial planners help reduce sequence of return risk for their clients by creating a plan for accessing cash when needed. This becomes particularly important when clients are relying on their investments for income, such as during retirement. But, it is important to address liquidity risk throughout the financial life cycle, so that clients always have a good place to get money in the case of an emergency or other unforeseen expense.
Insurance: Life, Long-Term Care, Health
Financial planners make insurance, also known as risk management, recommendations to their clients to address financial risks related to death, poor health, and longevity. Working with a financial planner to evaluate your insurance needs allows you to view insurance as part of your comprehensive financial plan, rather than as a stand-alone solution.
Investor Behavior
Perhaps the most underrated, but valuable risk management solution offered by financial planners is behavioral coaching. Financial planners can help reduce the risk of mistakes caused by investor behavior, such as abandoning your investment strategy in response to a sensational headline or short-term market volatility. Building a long-term relationship with a financial planner, and meeting regularly to discuss updates to your personal and financial situation, can help reduce the risk of missed planning opportunities, such as taking advantage of timely tax planning opportunities.
What Should I Do Next?
Risk is the reality that every outcome in life is guided, in some measure, by forces other than individual effort. Accepting risk, understanding risk, and managing risk is an important part of creating a financial plan that can withstand life’s many unknowns. Make sure your financial plan is risk ready by:
- Talking to your financial planner about your risk capacity, risk tolerance, and risk composure.
- Making sure your financial plan is addressing the risks you can control, and is well-positioned for addressing the risks you have some control over.
- Creating a risk management strategy to protect yourself from the risks you can not control.
Give yourself a strategic advantage by working with an advisor to help ensure your financial plan proactively incorporates risk management strategies, so that you can stay on track toward achieving your financial goals.
If you’d like a professional review of your financial plan’s risk profile, schedule a 30-minute, no-obligation Welcome Call today.
All investment strategies have the potential for profit or loss. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Insurance product guarantees are subject to the claims-paying ability of the issuing insurance company. Affiance Financial only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.
