How to Help Understand Personal Risks in a Financial Plan

By Sherry Hao, Controller at U.S. Money Reserve

Managing risk in your personal finances takes a lot more than just a balance sheet. Here’s what you need to know.

Here’s the deal: Risk is inseparable from return. Without taking some form of risk in life, you cannot get any kind of benefit. It’s true in finance, but it’s also true in practically everything we do. That being said, there are ways to mitigate or reduce risk and take smarter risks that can increase your chances of having a positive outcome.

Whether referring to risks in life or risks in finance, risk tolerance is incredibly personal. Some people enjoy the thrill of bungee jumping off bridges. Others choose different thrill-seeking adventures like hiking a tough trail or sailing in a harbor instead. Everything we do comes with a level of risk, and what you choose to do is determined by just how much risk you are comfortable with. The same goes for finances. Some people are comfortable trading options or playing in a highly volatile market. At the same time, others prefer to put their money in less risky financial instruments like CDs and bonds. No financial instruments on the market today are without risk, and that’s important to know and understand. There is no “sure thing,” but there are ways to manage your own personal risks and determine what they might be when it comes to making a financial plan. Here’s what you need to know.

Understanding the Elements of Risk

Risk is comprised of two main elements. First is the probability of the event (whether negative and positive) happening. Second is the impact that outcome may have on you and your financial situation. The truth is that you have to be able to pay attention to and understand both. We need to fully understand and investigate the potential risks of financial investments while ensuring that we don’t give some of those risks too much weight. For example, there’s always the possibility that the world economy could collapse, but if the last year of the pandemic has been any indication, the likelihood of that happening is rather slim — barring, say, a world war or massive environmental catastrophe.

In addition to these elements of risk, we also need to be aware of the extent of a risk and how it might affect us. For example, if you leverage your home to start a business, you have to realize that if the company goes under and you can’t pay back the loan you took out, you could lose your home.

How to Understand Your Own Risk Tolerance

The next aspect of helping to understand your personal risks in a financial plan is understanding your own risk tolerance. Simply put, risk tolerance is the level of risk you are willing to take on. How comfortable are you putting your hard-earned cash on the line? How much money are you comfortable risking?

Risk can bring opportunity, excitement, or a shot at significant gains, but risk can also mean loss. Taking risks involves a certain level of comfort with the knowledge that we cannot predict the future and that even the best decisions are susceptible to falling off a cliff. Behavioral scientists say that loss aversion, or the fear of loss, can play a more significant role in decision-making than the anticipation of gains and can impact how you feel about risk. The other thing to understand about risk is that you often won’t know your comfort level with it until you’re faced with a possible loss. This basically means you need to experience risk to know how comfortable you are with it.

It’s also important to understand that risk tolerance can be fluid. Sometimes risk tolerance can change based on your own risk-taking behavior. In some situations, extending ourselves beyond our comfort zone just a little can bring great rewards, which in turn builds our tolerance for risk. If a slightly bigger risk we take doesn’t go our way, we can think of it as a means to build our resilience, learn from our mistakes, and ensure that we don’t make the same errors in the future.

There are a few questions you can ask yourself to get a better handle on how comfortable you are with risk. These include:

• What is truly important to me when it comes to financial well-being (e.g., buying a home, supporting family, sending kids to school, saving for retirement)?
• What are my financial priorities?
• How much money am I comfortable losing?
• What am I comfortable with putting up as collateral (e.g., house, car, business, future financial stability)?
• What impact could losing this money have on my family?
• What are the potential rewards of this risk? How likely are they?
• Are there ways I can mitigate the risk and shift the odds more in my favor?
• What do I not know about this particular risk? What are my blind spots?

While this list of questions certainly doesn’t encompass all the questions you should ask yourself (and your family) about financial risk, it does offer a good starting point to begin thinking and talking about before taking on financial risk.

How to Understand Your Risk Capacity

Your risk capacity is very different from your risk tolerance. While you may be comfortable with a great deal of risk, for example, you may not be able to take on a high level of risk financially. While it sounds similar to your risk tolerance, your risk capacity is determined by your specific financial situation.

Realize that your financial situation can and will change, which means that your risk capacity will change over time. Thus, you should constantly recalibrate your risk tolerance and look closely at how your risk capacity has changed. For example, your risk capacity may have been greater when you were single than when you have school-age children. It may change again when you retire or when and if your income changes.

Take Stock of Your Timeline

Time also plays a critical role in determining how much risk you might be comfortable taking on, and it’s essential to acknowledge time’s influence. Shorter or compressed timelines can mean that you might think you can take on more risk, but in truth, longer timelines can often tolerate the ups and downs of, for example, a volatile market, much better than shorter timelines. Suppose you’re saving for retirement starting in your 20s. In that case, most financial advisors and planners recommend putting more in stocks rather than sticking to bonds since stocks often have many ups and downs but tend to head upward over longer periods of time and generate greater returns in the long run. In general, because you have a longer timeline, there’s more opportunity for it to recover from a downturn.

Use the Right Tools to Help Manage Your Risk

Whether you are doing it on your own, work with a financial advisor or planner, or work through a financial services company, you can use many different tools to mitigate your risk and still make an ample return. Many financial services companies use questionnaires to help build a picture of just how much risk you are comfortable with. If you do a quick Google search, you’ll find numerous resources to utilize.

While you’re assessing your risk tolerance, you should also check to ensure that you have the right level of insurance to help mitigate your risk. Insurance helps protect us from potential losses that could devastate us in the long run. Having the right level of medical insurance can mitigate your risk of going bankrupt trying to pay medical bills should something happen to you. Ensuring that you have life insurance can secure the future for your family should something happen to you. When considering your personal finances, it’s vital to take your insurance coverage into consideration and double-check that you have the right coverage.

The Bottom Line on Risk

While we cannot completely eliminate risk from anything in life, if we take time to understand more about it, manage it, figure out how much capacity we have for it, and use the right tools to manage it, we can turn risk into our greatest ally. After all, risk isn’t inherently good or bad — it’s simply a measure of what we are comfortable sacrificing for something that might potentially have great rewards. Once you have a firm hold on just what risk is, how much you can tolerate, what your risk capacity is, how much time you have to achieve your goals, and which are the right tools to assess your risk, you’ll be sure to find success when taking chances. Smart risks can bring enormous boons for long-term financial success. As they say, though, the proof is in the pudding. Ensuring that you are operating well within your boundaries is key to sustaining a healthy, thriving, and successful financial life.