Throughout most of the financial world, increasing wealth is seen to be the primary objective and driver behind sound financial management. Though this is an important facet of what happens in the mahogany lined offices of Wall Street or the lofty towers of Hong Kong, making money often plays a secondary role to another objective - preserving money. From bank managers, to equity analysts and all finance professionals in between, financial risk management is a key skill and valuable resource that helps managers of money know how much money they may lose from any particular event and how to preserve wealth in a crisis. Individuals and families too need these same skills in order to protect wealth and lifestyle.
Risk management is essentially the process of understanding the risks that affect you, measuring those risks and dealing with them. In the world of finance there are countless risks that could affect a business or wealth, and analysts will use stress testing techniques to gain better clarity about factors that could have negative affects. In the following, we look at some important risks that affect the family finances and what can be done to manage them:
Risk: Loss of Salary
The loss of income from a wage earner no longer working will usually have a dramatic impact on the family finances. This could occur due to a few main reasons being death, disability/illness and retrenchment.
Measuring: A family can quickly measure the absolute size of this risk by multiplying the salary of each wage earner by the number of expected years until retirement.
Managing: To protect the family against the loss of income from of a wage earner's death, disability or illness can be done through appropriate levels of life insurances (death cover, disability cover, trauma cover). Protecting against retrenchment cannot generally be solved via insurances, and one key protection (other than remaining indispensable) is to build up wealth in an emergency fund to cover costs whilst searching for new employment.
Risk: Loss of Assets
The loss of large assets such as a house or car can leave the family finances vulnerable or devastated.
Measuring: This is the value of the assets or cost to fully replace them.
Managing: In this instance general insurances such as home and contents insurance, car insurance, etc is available to help the family recover the loss of these physical assets.
Risk: Loss of Investment Value
A large concern for many families is the loss to wealth that could be incurred with investment values declining by a large amount.
Measuring: It is possible for the value of an investment to be wiped out. Among other things, this may be through bankruptcy of a company in which shares are held, through excessive gearing or through destruction of an uninsured asset.
Managing: Diversification is one of the key weapons you have to fight against the risk of losing some or all of your wealth. By spreading the risk of loss across various assets and sectors you will reduce dramatically the risk of large losses. Insurance of direct assets held (investment property, artwork, etc) is also critical. Furthermore, investment protection via the use of put options (or protected products with built in put options) can help put a floor underneath any potential losses.
Stress testing your family's finances by working out what risks you face and the different scenarios that could arise is an important part of overall financial planning. Whether you choose to avoid some risks (e.g. hold only risk-free assets), transfer some risks (e.g. insurances) or hold some risks (e.g. investment risks), through the risk management process you will gain an appreciation of what your worst-case scenario might look like and how to plan accordingly.