The Key to Understanding Financial Risk Management

"Life is inherently risky. There is only one big risk you should avoid at all costs, and that is the risk of doing nothing." - Denis Waitley*

Sometimes we don’t have the insight into financial risk management that we think we do. My wife, Sonia, works as a physician's assistant in a pediatric clinic right here in the Rio Grande Valley. Every day she's involved in critical "risk assessment" with patients. It's highly specialized work that she's received a lot of training for. (For more, see: 5 Investing Risk Factors and How to Avoid Them.)

Imagine a 12-year-old girl. She's brought to the clinic by her parents who are desperately worried about her continual weight loss. You or I might look at her and immediately think that we understand the risks - if she doesn't eat, she'll starve. Maybe we know there's a danger of malnutrition (though we might not know how to define that). When Sonia examines her, however, she understands "risk" at a whole different level. Health professionals know the symptoms to look for and can evaluate the patient's condition to determine what are both the immediate and the long-term dangers.

Financial Risk Management

Now, let's think for a moment about financial risk management. But let me help you with some insights that many don't consider. There's no question that the worldwide financial downturn of the last few years has left a lot of people less willing to take financial risks. We all heard the stories of investors who saw their savings drastically cut when the markets dropped.

Some people might think this new, more conservative mood is a good "correction." They think that it’s better to be safe than sorry. But hold on. It's very important to realize that it's possible to avoid one type of risk only to expose yourself to another. If your great fear of losing money in the markets causes you to hide all your savings under the mattress (or in a bank account that pays you negligible interest), you may sleep a little easier in the short term thinking your money is safe, but only to find you're in a bigger hole down the road.

The risks involved in investing can be calculated ones. There are ways to diversify your investments and hedge against big losses. Failing to invest at all, however, will virtually guarantee you a problem. The real risk is the longevity risk. This is the danger that you outlive your savings.

Inflation and Taxation

There are two great forces working against all of us and they need to be reckoned with: inflation and taxation. You've worked hard for years and your nest egg might look quite healthy to you right now. But what will that same amount of money be worth 15, 20 or 30 years from now when you need to draw on it in retirement? In short, you need a plan for your savings to earn money so that it keeps pace with inflation.

Many Americans get a rude shock when they lose a chunk of their carefully saved funds but it’s because they've failed to utilize the provisions available to minimize the taxes they'll be liable for in their retirement years. The fact is that no one can predict exactly what is going to happen in our economy in the years to come. There's no crystal ball to tell us which investments will do well and which will not. But these factors of inflation and taxation are definitely going to impact every one of us and they need to be planned for.

You see, sound financial risk management does not mean avoiding investments. It means making wise investments. (For more, see: Introduction To Risk Management.)

*Read more about Denis Waitley