Risk is something we all know as a situation involving exposure to danger. While risk is attractive to some, it’s often something others try to avoid. Where your financial plan is concerned, risk is not fertilizer that makes a portfolio magically grow. But everyone has their own definition of risk, depending on their own experiences.
In fact, when it comes to risk, the stock market is one of the first things that comes to mind for many people. And with that, they immediately think “big loss.” But risk can be good or bad. Taking a big risk on something like the stock market and getting a hit can make you highly successful—that’s a good thing. Of course, exposing yourself to unnecessary dangers is when risk becomes a bad thing—whether in the stock market or elsewhere.
There are all kinds of risks when it comes to wealth. Understanding and controlling risk over extended periods of time is one of the most important aspects of the financial planning process. The following are some of the risks that can make a big impact on your results now and into the future.
1. Market risk is defined by the asset class that you are investing in. Subsets of market risk include stock market risk. Investing in the US stock market usually involves the S&P 500, Nasdaq, or Dow Jones Industrial Average. Stock market risk also includes the broad markets and hedging out many stocks—in other words, owning several hundred stocks to balance out the ups and downs. Another subset of market risk is industry risk, or putting all your money in one individual market sector. For instance, because people always need to power their homes and businesses, energy stocks might seem like a good sector to invest money in. Then there is company risk, which is having your entire portfolio with a single company. People sometimes benefit from having single-stock concentration. There are a number of names on the Forbes 400 list whose wealth is in a single stock—Jeff Bezos of Amazon comes to mind. But sometimes having an entire portfolio made up of one stock is detrimental—like when a company goes under.
2. Economic risks are all the types of monetary risks associated with a plan. These risks include factors such as income and liquidity, interest rate and taxes, withdrawal rates and estate taxes. Using estate tax as an example, in the past, there used to be high taxes imposed on an inheritance, but over time, the laws have changed. Currently, new tax laws have created complacency where estate taxes are concerned. For a wealth plan with a nice, $8 million estate through life insurance and investments, inheritance tax would not factor in. But in the future, the laws could change and create a completely different scenario—that’s a risk.
3. Assumption risks are based on current “knowns.” When building a wealth plan, certain assumptions based on your “knowns” are taken into consideration —you know you make a certain amount of money. You know you pay a certain level of tax. You know your family structure. But too often, wealth plans are created based on the assumption that the variables in it are not going to change. In 1982, for example, when a ten-year treasury was at 15.81 percent, $5 million in the bank at 15 percent created a lot of income. But to base an entire wealth plan on the assumption that it will experience 15 percent growth for the long term would have created a lot of risk—as we all know, that kind of growth has not been consistent. Some of the most common poor assumptions often include: your income is going to increase regularly and at a certain amount, you’re going to save a certain amount of money every year, you’re going to make a certain rate of return, tax rates won’t change, dishwashers and refrigerators will never break down, you won’t need new technology. Plan for everything to change – because it will.
4. Insurability risk is the ability to protect yourself against the risks in your plan. There are known risks, or things that you know may happen to you. And then there are unknown risks, or things you can’t predict. Financial plans can include protections for a variety of known and unknown risks, including property and casualty, lawsuits, health, disability, long-term care, and death. The goal is to have maximum coverage for the least amount of cost so that, no matter the circumstance, your wealth is protected. When creating a plan, people often don’t want to calculate in risk because of the devastating picture it can paint. As human beings, we tend to underestimate the severity or consequences of risks until they impact us directly. That mindset, in itself, is risky when it comes to a wealth plan. When planning for the future, we must look at all the relationships that expose you to a level of potential danger.
No one is immune to risk—now or in the future. The key to managing risk in financial planning is to figure out what can be reduced or offloaded to a third party with strategies designed to protect you and your future. If 2020 has taught us anything, it’s that risk, change, and uncertainty are inevitable. Take greater control of the risks associated with your financial plan.