To a degree, everything that you do has some amount of risk involved. It doesn’t matter whether you’re walking across the street or skydiving; there’s always a chance that something won’t go as you planned.
Every day, you use risk reduction strategies to increase the chances that events turn out favorably for you. You do things like looking both ways before crossing the road or learning about the drop zone before jumping out of an airplane.
Personal finance is no different. You can be frugal with money, save, and invest; yet you still may face financial hardship at some point in the future!
On your journey to wealth creation, you’ll face many risks. [link] The primary ones are losing your ability to make money, pay bills, and earning a good prolonged rate of return.
There are many risk reduction techniques available to you. Each one lowers your chances of falling upon hard times or suffering from a large financial loss. Use the strategies listed below to limit the likelihood that you’ll face financial storms which allow you to go on and win at the game of money!
There is no telling when a financial emergency will occur. It could happen next month, next year, or even further down the road. But, it will happen and usually does when you least expect it!
To help pay for these sudden expenses, you need an emergency fund. It’s an account that you put money into and don’t touch until you need it.
Without an emergency fund, you’ll need fast cash when disaster strikes. You’ll likely have to borrow funds, waste money on interest, and eventually dig yourself out of a financial hole!
You can reduce the risk of this happening to you by building an emergency fund. Start by saving 3-6 months’ worth of your monthly expenses and keeping the money someplace safe and accessible, like a HYSA. By keeping your emegency fund liquid, you’ll be able to withdraw the funds at a moment’s notice without having to stress over where you’ll find the money.
Consumer debt comes from living above your means and spending money that you don’t have. It’s created from purchases you’ve made in the past and now they’re a risk to your financial future!
Most debt comes with high-interest rates, too. According to an article on The Balance, the average rate on unpaid consumer debt is over 20%! That’s more than double the amount most people earn on their investments and is a big drain on their finances!
High rate debt significantly affects your ability to create wealth. It continues to grow and compound larger until you create a plan and can get rid of it.
If you have high rate debt, reduce your risk and escape the handcuffs by paying it off. When you do, your burn rate gets lowered and you’ll have more options to live life however you choose!
Many people struggle to save money because they haven’t planned or made an effort to. Often, they’ve spent their wages long before the money’s ever hit their account which keeps them stuck, living paycheck to paycheck.
However, it’s possible to break free of this cycle by creating and following a budget. This money tool establishes a way for you to use your income so that you’re able to spend within reason and save!
Saving money is the key to creating your cash runway. It’s the starting point that allows you to experience freedom and pursue whatever it is that brings you happiness in life!
I know, I bad-mouth insurance companies a lot. Despite them being guilty of bill creep, they do have some redeeming qualities.
Insurance companies shield you from many of life’s uncertainties. They reduce your risk of suffering a large loss by promising to pay (under specific conditions) if something unexpected happens to you.
At a minimum, most experts recommend that you carry home, car, and health insurance. Depending on your family’s financial situation, life insurance could be another smart protection, too.
One of the biggest risks a full time employee faces is losing their income completely. Most employees have become increasingly reliant on their jobs to support their lifestyle and pay for their expenses.
What happens if these same people get fired or find themselves in a position where they can no longer work? Without their sole source of income to rely on, they’re left depending on savings and investments to meet their needs. This also stops the power of compounding in its tracks, forcing them to work longer to reach their financial goals!
However, those who have multiple streams of income are less likely to get affected by these events. Because they’re bringing in money from several different places, a reduction or elimination of one source does not completely stop their cash flow!
Believe it or not, creating a new stream of income is easier than you think. You could rent out things that you already own, join the gig economy, or buy cash-flowing assets. Each additional stream you create further diversifies your income and reduces your risk of not being able to pay bills.
One of the oldest rules for investing is to never put all of your eggs into one basket. And just like we learned above, by not doing this you’re reducing your dependency on a single company’s performance.
Spreading your investment dollars between many companies reduces your risk. It makes you less vulnerable as well as less likely that you’ll lose money.
For example, imagine you have the option of owning stock in one company or twenty. If you own just one stock and that company goes bankrupt, then you’ll lose everything. But, if you own twenty stocks and one goes to zero, then you’ll have only lost 5% of your money!
No one likes losing money and diversification won’t protect you entirely. Even by owning many different companies’ stocks, you’re still open to market risk which is why you also need to consider…
Diversification is a risk reduction strategy that divides your investment capital amongst multiple securities all within the same market. But, it doesn’t protect you from negative events that could happen to the asset class as a whole, like a market crash.
To reduce your risk further, invest in multiple types of assets. Consider buying securities that have little to no correlation or ones that move in opposite directions of each other. This way, when one market goes down, the others won’t be as impacted and some may even rise!
It’s important to understand that your asset allocation is not constant. It’s in constant flux and as you experience financial gains and losses you can also reduce risk by…
As you buy different assets, you’ll naturally have some that do well, others that do nothing, and a portion that lose money. Over time, you’ll own a greater portion of the ones that have done well relative to the ones that haven’t which may expose you to greater risk.
But, portfolio rebalancing reduces this risk. It’s a technique that involves selling part of your assets that have performed well and using the proceeds to buy the ones that haven’t. This rebalances your asset allocation and resets it to the way you started.
For example, imagine that your ideal asset allocation is 75% stocks and 25% bonds. If stocks perform well, the percentage of them that you own increases. So, if you have 80% stocks, then you’d want to sell some and buy bonds which would rebalance your portfolio and reduce your risk!
It’s important to rebalance your portfolio as you age, too. You don’t want unnecessarily high-risk assets that fluctuate in value and can affect your retirement. Instead, you’d sell assets that vary and buy ones that are more stable and predictable. This way you won’t risk losing a large amount of money and not have time to recover from it!
There are two primary ways to rebalance your portfolio. You can do it yourself or invest in assets that do it for you.
Target Date Funds are set up to rebalance automatically. As they get closer to their target date (ie. retirement) they adjust to a more conservative financial strategy which reduces your likelihood of sequence of return risk.
For many people, risk is scary, dangerous, and potentially harmful. But, it’s something you can learn from, too. Risk can help uncover your money personality, weak spots in your financial plan, and areas where you can improve.
All of these risk reduction techniques lower your chances of not being able to recover from a loss. But, unfortunately, they can’t eliminate risk completely.
Which risk reduction strategy has helped you the most? Comment below.
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