Risk management: What's the worst that could happen?

We face risks each day of our lives. Most of us avoid thinking about risks, because they are either to numerous or too remote to worry about. It seems common, in fact, to waste energy worrying about things that will never happen. That is not to say that we should never plan for negative outcomes. The approach I recommend is to “hope for the best, but plan for the worst.” In other words, manage your risks.

The term “risk management” is used different ways in different industries. In banking, it means: what is the most we could lose in a given timeframe? In corporate finance, it means: how much could a change in fortunes at the other company affect our balance sheet? In financial planning, it usually means: an insurance pitch. Risk management is at least as much art as it is science. The US banking industry found this out when their faulty science led to the credit crisis during 2008. Possibly the most effective way to manage risk is to think of all the risks you face, then decide how you will address each one.

There are four possibilities when deciding how to address risks that you face. You can either accept the risk, reduce the risk, insure the risk, or avoid the risk. Let me offer a couple examples of each. Some of the risks I accept include: getting food poisoning at a restaurant, a helicopter crashing on me as I walk to work, or losing my job. Some of the risks I try to reduce are: injury in a car accident (by wearing a seatbelt and driving a car with airbags), drowning while boating (by wearing a lifejacket), and having my house broken into (by locking doors). Some of the risks that I insure include: dying before retirement (with life insurance), being unable to work (with disability insurance), and losing my house or belongings in a fire (with home insurance). Some risks I avoid altogether are: losing money in a casino, being hit by a car while riding a motorcycle and any drug-related risks.

The worst things that could happen to derail your financial plan are specific to you, and different people, even when facing the same risk, may react differently. The following are some suggestions to consider. Put into place your own solutions, and you will have peace of mind, which allows you to focus on more meaningful activities.

We will all die one day, so the risk of death is actually certain. You may, one day, be ready for death, but what happens if you die too soon? If no one is dependent on you, you can accept the risk. If your family depends on your income, you can buy life insurance to replace the income. When you are financially prepared to retire, you no longer need insurance to replace your income. If your business depends on you, you could prepare a clear succession plan. If a foundation depends on you, you could set up a trust with a clear indenture. Most of these issues are referred to as “estate planning.”

The chances of suffering a disability are greater than dying prematurely. You may be able to rely on family or friends to care for you during a disability. Some people prefer to be independent, or already have family who depend on them, so they buy disability insurance to create income. Debt often becomes the greatest burden for people who are unable to work, so keeping debt under control is one way to reduce this risk.

It’s probably safe to say that no one who gets married, plans to divorce, but it happens to almost half of all couples. Some problems that might follow a divorce include splitting illiquid assets, increased child care costs or travel costs, spousal and child support payments, and legal costs. Besides that, estate planning issues need to be reviewed, such as inheritance and guardianship. Further, if one spouse stayed out of the workforce to raise children, that person may be at a disadvantage when returning to work. Some of these issues can be addressed with a prenuptial agreement, others with the separation agreement. Sometimes, using a divorce counsellor or arbiter instead of a lawyer can save cost and improve the agreement.

What ideas do you have for dealing with the loss of your job? What if you were held legally liable for someone’s injury or loss? Would you be prepared in the case of a natural disaster or a war? I hope never to have to deal with these issues, but it may be helpful to have a plan.

The last risk I will address is market loss. This is a sure risk for anyone who invests in stock market-related investments, either ETFs, mutual funds or individual stocks. Many people feel that they’ve lost money when the market value of their account decreases. You could avoid this risk by not investing in stocks, but you will also miss out on the growth and dividends of stocks. To be fair, bonds have often returned as much as stocks, and term deposits did better in the early 1980s. You could reduce your risk by investing only a portion in stocks or by owning a market-neutral hedge fund. You could try to insure your risk by owning segregated funds, principal protected notes or options; these types of insurance each have a cost. Or you could accept the risk. Accepting the risk means not selling in panic when the market value falls and not buying in euphoria when the market surges ahead. Not everyone has the constitution to accept the risk of a market loss, but if you understand investing, accepting this risk can be profitable.

We are each faced with many risks in our life. The way we choose to respond depends on our individual personality and outlook. It’s beneficial to consider the risks that you face and choose whether you will avoid them, reduce them, insure them or accept them. If you will reduce or accept the risk, have a plan on how you will deal with it. Then, inform your family or anyone who depends on your or upon whom you may depend, so that everyone can react appropriately in a difficult situation.