Risk planning is an often neglected part of financial planning. In fact, if certain risk covers were not prescribed by law, a lot of us will opt not to take any insurance for any form of risk.
This is because we often either underestimate the probability of occurrence of events or overestimate our capacity to recover from risk events that have high chances of occuring and rather focus on events that our fear of their occurence far outweigh the chances that they could ever occur. An example is deciding to drive for a long distance trip in an 'uninsured' vehicle because of your fear of a plane crash.
Risk is an integral part of life and some risk taking is necessary for growth especially when it comes to wealth creation but other risks are unnecessary and easily avoidable.
Risk planning must be a core part of your personal financial plan because the occurrence of risk events can suck money out of your well planned finances if not identified and already catered for in your plan.
The starting point in your risk planning and management journey is to first identify the risks you face and then use the most appropriate elimination or mitigation methods to manage that risk.
5 Risk Management Methods
The most common way we know of managing our risk exposures is through insurance. Unfortunately, not all forms of risks can be reasonably insured even if you identify all your exposures.
But there are other methods of risk management that when used effectively in a comprehensive plan will reduce the overall impact of an adverse event if and when it occurs. The 5 main ways are:
- Avoidance - Some risks can best be managed by completely avoiding the situation that increases the chances that it can occur.
- Reduction - Other forms of risk can be managed by reducing the chances that they will occur. Such as installing a burglar alarm to reduce the chances of a theft.
- Retention - This is where you voluntarily or involuntarily retain the risk and is often referred to as 'self-insurance'. It only makes sense to use this method when you have the financial resources to cater for the loss, where the chances of occurrence is negligible or when risk is uninsurable and when none of the other forms of mitigation or elimination also work.
- Transfer - In this case you transfer the risk to another party willing to accept it. The most common way of transfer is through insurance, another is through an indemnity.
- Sharing - Here you assume a manageable or limited amount of the risk and transfer the rest to another party. Such as when you use a contractor for your constructing project who has insurance cover.
The most important tasks are to first identify your exposures and then based on the nature of each risk, decide which one of the 5 methods will be most effective in managing that risk based on your individual circumstances.
In the case of investing, this cover will include making sure that the return you expect from that investment is sufficient relative to the risk of loss on the investment that you may experience.
Here is a great video advocating for Risk Literacy by Gerd Gigerenzer that is well worth watching to the end.
What challenges do you have with risk management? Is it identfying, estimating chances or deciding on the best way to manage it? What successes have you had? Share you experiences by commenting below to help others.