What is risk management?
Risk management is the process of identifying risks and then addressing them in a way that reduces the impact on your ability to reach your goals. There are multiple steps, and the process should be repeated or reviewed on a regular basis. As life changes, your environment and situation change, and your goals may change, too. The risks that can potentially affect your financial future also change.
Identification of risk
The first step in the risk management process involves identifying risks. Risk is anything that threatens your financial stability or your progress toward your goals.
Here are some examples of risks that you might identify:
- The risk in your investment portfolio
- The possibility that the large tree limb hanging over your house falls on your roof
- The possibility that the new driver in your household knocks over your neighbor’s mailbox
- The risk that you or your spouse lose your job
- The risk that you experience an illness or injury that prevents you from earning an income
- The possibility that someone gets hurt on your trampoline
- The risk of premature death of the primary breadwinner in the household
- The risk of a major illness or injury requiring hospitalization
- The possibility that you or a family member requires a long period of medical care or convalescence
- The possibility that an airline delay means that you miss your planned vacation years in the making
- The risk of a flood that damages your household belongings or the structure of your home
- The possibility that a rock bounces on the road and then breaks your windshield
Risk management strategies
Depending on the types of risk you identified, you have different options to manage and hopefully reduce any potential impact on your financial well-being.
Eliminating Risk
Among the first strategies to consider is elimination. Can you eliminate the risk entirely? For example, consider removing a trampoline from your yard to eliminate the risk of someone getting hurt and either incurring major medical expenses or possibly resulting in a lawsuit judgment against you.
Mitigating Risk
In some cases, there are steps that you can take to minimize the effects and financial impact of a risk event. For instance, diversifying your portfolio is a method of mitigating the risk from adverse events affecting some of your investment holdings. Concentrating all of your portfolio in a single stock, on the other hand, leaves your entire portfolio overly exposed to risks associated with a single company.
Risk Retention
Retention of risk involves acknowledging and accepting a particular risk. An example of risk retention would be creating an emergency fund. There is the chance that your refrigerator dies unexpectedly while full of food. Using your emergency fund to pay for a new refrigerator on short notice, hopefully saving your food, is a method of retaining the risk.
Transferring Risk
Insurance is the risk management strategy most people are most familiar with, and it falls within the transferring risk category. This involves shifting the risk to an insurer from the customer’s point of view. When you purchase insurance for a particular event, you are transferring the risk that the financial burden resulting from the event will be borne by you to being borne by the insurer.
The critical nature of Risk management
It is important to go through this process on a regular basis; this is not a one-and-done process. Your circumstances change over time, and your resources change over time, which means that the financial resources you need to protect also change. The risks that apply to you also likely change over time. You’ll need to regularly review and update your risk management plan to identify and address the most important threats to your financial future.
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