- Risk management in personal financial planning takes much more emotional intelligence skills than actual knowledge in finances and economics. A personal financial plan is key to evaluate the risks you are taking versus your potential earnings.
- Are you an investor or a gambler? To succeed financially and properly manage risk with your personal financial planning you must be a bit of both.
- Everybody wants to win. In order to do so, you must take risks, and in order to succeed consistently, you must ensure risk management in personal financial planning takes place.
Risk management in personal financial planning
Managing your money is no easy task. Everybody wants to win, of course. But not everybody wants to bet, and therein lies a significant difference. There is no formula for personal finance management, but risk management in personal financial planning will leverage your investment decisions. You might already be taking care of your personal finances by doing a family budget and controlling your expenses, income, debt, and investments. This is great and will keep your finances under control. But it will not make you rich.
The world of money is a world of pattern-less disorder, utter chaos. Prices of stocks rise and fall because of what men and women are doing, thinking, and feeling. Your ability to profit from it will depend on your risk appetite and on how well you deal with uncertainties.
Many people, probably most, want to win without betting. This is an entirely understandable wish. There is nothing objectionable about it. Indeed, many of our hoariest old Work Ethic teachings urge it upon us. We are told that risk-taking is foolish. A prudent man or woman places no bets beyond those that are required by the unalterable basic terms of human existence.
Why risk management is important?
Usually, people consider only the risk of losing money. If you want to get rich, you must also consider the risk of mediocre results.
The three personal finance lessons that I will present in this post are the basics needed to set up your financial goals. I see a lot of people answering investor profile questionnaires and getting a good feeling for having an “Aggressive” profile, or “high-risk appetite.” Indeed, higher gains are typically achieved with higher risk, but so are higher loses. That is where risk management in personal financial planning, you must be able to gauge what risk level makes sense to your current life situation, and to your long term goals.
Emotional-based personal financial planning risk management
Worrying about money is not a sickness but a sign of health
There is an old story about a fellow who stands on a street corner every day, waving his arms and uttering strange cries. A cop goes up to him one day and asks what it’s all about. “I’m keeping giraffes away,” the fellow explains. “But we’ve never had any giraffes around here,” says the cop. “Doing a good job, ain’t I?” says the fellow.
It is characteristic of even the most rational minds to perceive links of cause and effect where none exists. When we have to, we invent them. The human mind is an order-seeking organ. It is uncomfortable with chaos and will retreat from reality into fantasy if that is the only way it can sort things out to its satisfaction. Thus, when two or more events occur close, we insist on constructing elaborate causal links between them because that makes us comfortable. It can also make us vulnerable, but we don’t usually think of that until it is too late.
Worry is not a sickness but a sign of health. If you are not worried, you are not risking enough. Perhaps freedom from anxiety is helpful in some ways. Emotions play an important role in risk management in personal financial planning. But any good speculator will tell you that if your main goal in life is to escape worry, you are going to stay poor. You are also going to be bored silly. If you want to avoid poor money management and make some cash while doing so, you must know how to take risks, and that means knowing how to speculate.
The truth about speculation
All investment has a speculative factor
People who offer to counsel you in money management almost always call themselves “investment” advisers, not speculation advisers. It sounds more serious and impressive that way. Understanding that gambling and betting are part of the investment reality is key for proper risk management in personal financial planning. All investors are dealing with speculation, they just don’t like to say it.
How to manage risks in your personal financial planning:
- Always play for meaningful stakes
If you risk, bet $100 and double your money, you’re still poor. Risk management is used to have your worst-case scenario covered. Work on your personal finance plan taking real risks and play for meaningful stakes. This is the only way to leverage your personal finances.
- Resist too much diversification
When considering personal finances risk management, Andrew Carnegie Quotes: “The way to become rich is to put all your eggs in one basket and then watch that basket”. Your personal finance should be simple, focused on key assets with high potential earnings. Overdiversificate and risk pitiful results.
- Always take your profit too soon
Don´t be greedy, don’t wait until it is too late, keep your risks in check at all times. Once you have reached your personal finance plan target, exit with a profit.
3 Lessons on financial risk management
Lesson 1: Always play for meaningful stakes
“Only bet what you can afford to lose.”
… and chances are you will continue to be poor
You hear this wherever people risk money to get more money. Be it in Wallstreet or Las Vegas, you read it in books of investment and money-management advice by conventional counselors. It is so often repeated that it has taken on an aura of truth through assertion. By interpreting it in the way people usually do, “only betting what you can afford to lose” is a formula that almost always assures poor results.
What is an amount that you can “afford to lose“? Most would define it as “an amount which, if I lose it, won’t hurt.” A few hundred or thousands is what most middle-class people would consider loss-affordable. And as a result, these are the kinds of amounts most middle-class people speculate with if they speculate at all.
But consider this: If you bet $100 and double your money, you’re still poor.
The only way to beat the system is to play for meaningful stakes. This doesn’t mean you should bet amounts whose loss would bankrupt you. You’ve got to pay the rent and feed the kids, after all. But it does mean you must get over the fear of being hurt. If an amount is so small that its loss won’t make any significant difference, then it isn’t likely to bring you any considerable gain either.
Lesson 2: Resist too much diversification
As used in the investment community, diversification means spreading your money around.
Spreading it thin. Putting it into a lot of little speculations instead of a few big ones. The idea is safety. If six of your investments get nowhere, maybe six others will get somewhere. Now, if one company goes bankrupt and the value of your stock drops to 3 cents, perhaps another of your speculations will turn out better. At the same time, if everything collapses, maybe your bonds, at least, will increase in value and keep you afloat.
The fact is that diversification while reducing your risks, reduces by the same degree any hope you may have of getting rich.
Most of us middle-class plungers, at the start of our speculative adventures, have only a limited amount of capital to play with. Let’s say you have $5,000. You want to make it grow. What are you going to do with it? The conventional wisdom would say diversify. Make ten bets of $500 each. Buy $500 worth of Tesla, put $500 in a savings account in case interest rates go up, $500 into gold in case the bottom drops out of everything, and so on. There — you’re covered for all kinds of eventualities. It makes you feel safe, doesn’t it? Safe from just about everything — including the danger of getting wealthy.
Lesson 3: Always take your profit too soon.
Amateurs on Wall Street do it so amateurs in poker games. In reality, enthusiasts everywhere do it. They stay too long and lose. Always bet on the short and modest. Don’t let greed get you. When you have a good profit, cash out and walk away. Once in a while, you will regret having walked away. The winning set will continue without you, and you will be left morosely counting all the money you didn’t make.
In hindsight, your decision to quit will look wrong. This depressing experience happens to every speculator once in a while, and I won’t try to minimize it. It can make you want to cry. But cheer up, to match against the few times the decision to quit early turns out wrong, there will be a dozen others where it was the right call.
In the long run, you make more money when you control your greed.
Why should you take risks when investing?
Here is the cold truth:
Unless you have a wealthy relative, the only way you are ever going to lift yourself and become rich — absolutely the only hope you have — is to take a risk.
Yes, of course, it is a two-way street. Risk-taking implies the possibility of loss instead of gain. If you speculate with your money, you stand to lose it. Instead of ending rich, you can end poorly. That is why risk management in personal financial planning is so important.
But look at it this way. As an ordinary tax-hounded, inflation-raddled income earner, carrying much of the rest of the world on your back, you are in pretty sorry financial state anyhow. What real difference is it going to make if you get a bit poorer while trying to get richer? You aren’t likely to get much more miserable. But you can get very much wealthier. There is farther to go upward than downward — and no matter what happens, you will have an adventure. With the potential gain so much more significant than the possible loss, the game is rigged in your favor.
Financial literacy and risk tolerance
One question that you should ask yourself is what is your financial risk tolerance. In other words, what is the maximum amount of uncertainty that you are willing to accept when making a financial decision? This question reaches into almost every part of your economic life, it is on the basis of personal finances and to understanding how to manage money. You should have it present when choosing your credit card, taking a student load, or deciding the size of your house mortgage. Several factors will influence how much risk you are willing to make, and your risk threshold you certainly change during your life. Your risk appetite will be affected by factors like your age, marital status, occupation, employment stability, net income, and your own future goals.
One critical step to be reasonable and take moderate risks with money is to improve your financial literacy. Financial literacy is about enabling you to make informed and confident decisions regarding all aspects of your budgeting, spending, and saving. It is also related to how well you can use financial products and services, from everyday banking to borrowing, investing, and planning for the future.
Personal finance risk management practical examples
Let´s review some practical examples of how important risk management is for your personal finances.
Example 1: Retirement planning
One of our most significant financial decisions is how to save for retirement. After all, building a fat retirement savings portfolio over time is the best way of achieving financial security.
As any good financial planner will tell you, saving for retirement does not come without risks. You will only be in good financial health late in life if your investments are still paying off good returns.
In the United States, the Society of Actuaries (SOA) has identified a number of post-retirement risks. Understanding them is vital as they can affect your retirement plan income and undermine your financial security:
- Personal and Family: Changes in your life or the life of a loved one can impact your financial health. Be prepared for employment issues, change in marital status, and needs of other family members. Your own longevity and that of your family members can be much higher than what you are expecting.
- Healthcare and Housing: The need for professional caregivers or moving to a facility due to failing health must be taken into consideration. You must plan for unforeseen medical bills, the need to change to different housing, and the lack of available caregivers and care facilities.
- Financial: Rising inflation, fluctuating interest rates, stock market losses, and poorly performing retirement plans might affect you late in life. As your life horizon is much lower now than before, you might not have enough time to recover from investment losses.
- Public Policy: Governmental decisions can affect retirees, including the possibility of higher taxes and reduced benefits. Always have your backup plan in case the government decides to let you down.
Example 2: Debt
Any financial advisor will tell you that debt plays a critical role in your financial life. The trick is to manage your money in a way that debt becomes something positive, instead of a burden. Always make sure you have enough in your checking account to pay your debts on time.
The best option would be to have no debt at all, but that is not always possible. A student loan might be your only option to access quality education, and that´s fine. Credit card debt can be used to get a good credit report, but if you are not careful, it can easily spiral out of control.
Living completely debt-free is not necessarily a good thing. Most people do not earn enough money to pay cash for life’s most important milestones: a house, a car or a quality college education.
At the same time, paying off your debt might turn out to be harder than you think. Most graduates are not out of debt until many years after college. Worryingly, during all this time of fighting to get out of debt, their retirement account stays flat.
Whenever you buy credit or take a loan, ask yourself if you are incurring good debt or bad debt.
Good debt is an investment that will grow in value or generate long-term income. My rule of thumb is that your debt should pay itself in 10 years or less.
For example, taking a student loan can be both good or bad debt. It all depends on how big your paycheck will be once you get your degree. It is true that student loans typically have a very low-interest rate compared to other types of debt. But the critical question is how much this degree will raise your potential future income.
Example 3: Health Insurance
Everyone faces health risks. In the absence of a good health insurance, a serious disease or accident can devastate a family’s financial security. Insurance allows you to transfer the consequences of the financial loss to the insurer.
At the same time, the insurance company is running a business. We must watch out for the insurance coverage fine print, and understand all applicable insurance premiums.
A risk management plan helps families and individuals manage their exposure to uncertainty and financial loss by identifying major risks and determining suitable protection through various insurance products.
Having life insurance might sound like an obvious necessity, but in many cases, it might not be the case. Life insurance does not make your life safer, risk avoidance does.
Example 4: Investment portfolio
Choosing where to invest might be the single most important decision when it comes to your financial future. Once you have your emergency fund set up and your debt under control, it is time to start thinking about the risk profile of your investment portfolio.
More than choosing the right mutual fund or picking the best stock, you should focus on the correct asset allocation for your risk appetite. Decide how much you are willing to risk, discover how you deal with volatility and uncertainties.
Once you understand yourself, build an asset allocation plan. Define how much you are going to invest in each asset class.
You should start buying financial products only when you have defined your asset allocation plan.
Where to go next? Invest in your financial education!
Learn how to master the game of money with Financial Freedom: my only hope. This bestselling book by Jeremiah Brown will give you a blueprint for how to go achieve financial freedom. He addresses stewardship of money in quite a lot of detail. He also does a great job of identifying the ways we lie to ourselves, let alone others, about what we are doing with our time and money.
Continue reading and learn more about finances:
- Family budget: 6 easy steps to reach financial freedom
- 6 proved steps on how to manage money and unlock financial freedom
- Hope, Predictions and Historical Data: 3 recipes for financial failure
- How to take risks when managing your money? 3 lessons I learned to avoid poor money management
Source and comments:
This post is based on my personal experience of more than 10 years of investing, and from lessons that I have learned on the book The Zurich Axioms: The rules of risk and reward used by generations of Swiss bankers
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