Four Ways to Manage Risk - Capstone Capital

Every risk we face can be addressed in one of four ways. Each may be an appropriate choice: Avoidance, Reduction, Transfer, Retention. FourWaystoManageRisk FourWaystoManageRisk Everyriskwefacecanbeaddressedinoneoffourways.Eachmaybeanappropriatechoice,dependingonthecircumstancesandtypeofriskinquestion: Avoidance Reduction Transfer Retention AvoidingRisk   Thesurestwaytopreventthepotentiallossarisingfromacertainactivityistocompletelyavoidit.Forexample,ifIwanttoavoidthepossibilityofhavingtopayforastranger’smedicalexpensesduetoanautoaccident,Icouldstopdrivingacar.Sowhynotjustavoidallrisks?Theproblemisthatwheneverweavoidariskwealsomissoutonthebenefitswecouldhavereceivedforparticipatingintheassociatedactivity.Inaddition,notallriskscanbecompletelyavoided,suchastherisksofillnessornaturaldisaster. WhyYouDon’tWanttoAvoidAllFinancialRisk Avoidancemaybeappropriateforalimitednumberofrisksthatproduceahighprobabilityofloss,suchasgambling,butitisnotapracticalsolutionformostrisks.Insomecaseswemayevencreateadditionalrisksbytryingtoavoidaparticularrisk.Forexample,wemaybetemptedtokeepallofoursavingsincashtoavoidtheriskofinvestmentlosses,butthenwewouldbesubjectingourselvestothepotentialriskoflossbyinflation,whichispracticallyguaranteedtosignificantlyerodethevalueofourcashovertime. ReducingRisk   Ifweareunableorunwillingtoavoidanactivity,wecantakestepstoreducetheprobabilityandpotentialseverityoflossassociatedwiththeactivity.Forexample,whenwechoosetodrive,wecanreducetheriskofbeinginvolvedinanautomobileaccidentbyobservingthespeedlimitandothertrafficlaws,nottextingwhiledriving,andnotdrivingwhiledrowsyordrunk.Wecanalsoreducetheseverityofinjurytoourselvesinthecaseofanaccidentbyalwayswearingourseatbeltsandbydrivingvehicleswithairbags.Othercommonexamplesofriskreductionincludeinstallingburglarandfirealarms,buildinglockedfencesaroundpools,andvisitingthedoctoronceayearforaphysicalexam.Wheninvesting,wecanreduceriskthroughproperduediligence,diversification,seekingtheadviceofqualifiedexperts,andinvestingprimarilyinthatwhichweunderstandorcancontroltosomeextent. TransferringRisk   Anotherwaytodealwithrisksweareunableorunwillingtocompletelyavoidistotransferthemtoathirdparty.Wecantransferriskinseveralways,butthemostpractical,cost-effective,andcommonapproachforhigh-severityriskswithalowprobabilityofoccurrenceisthroughinsurance.Themosteffectiveuseofinsuranceistocoveronlytheunlikelypotentiallosseswhichwouldfinanciallydevastateusiftheyoccurred.Intheseareas,weshouldseektomaximizeourprotectionandminimizethecost. EffectiveExampleofTransferringRiskthroughInsurance Lifeinsuranceisoneexampleofappropriaterisktransfer.Ifayoungbreadwinnerwithanon-workingspouseandsmallchildrenweretopassawayprematurely,hisorherfamilywouldfindthemselvesinaverydesperatefinancialsituation.Ayoungfamilyisnotlikelytohaveenoughassetstocareforitsownlong-termneedswithoutthebreadwinner’searnedincome.Withoutadequatelifeinsurance,theburdenofprovidingforsuchafamilymayfalluponextendedfamily,friends,church,orcommunity. Aftercarefullyconsideringthefullpotentialimpactofsuchanevent,mostpeopleinthissituationwouldrathertransfertheriskofprematuredeathtoaninsurancecompanybecausetheywouldneverwanttobesuchaburdenonotherpeople. RetainingRisk   Ifwedonotmakeaconsciousdecisiontoavoidortransferarisk,thenbydefaultweretainit,acceptingfullresponsibilityforthepotentialloss.Insomecases,retainingariskisnobigdeal.Inothercases,retainingariskcouldcompletelydevastateus.Retentionisthemostsuitableapproachwhenthepotentialseverityofalossislow,regardlessofhowfrequentlyitisexpectedtooccur,orifthecostofinsuringtheriskwouldbehigherovertimethantheactualpotentiallossincurred. ExampleofWhenRetainingRiskisBetterthanTransferringRisk Agreatexampleofthisistotalreplacementcoverageforacellphone.Whenrecentlyupgradingmywife’scellphone,Ichuckledatwhatourserviceproviderwasoffering.Themonthlypaymentfortheirtotalreplacementinsuranceplanwouldbeenoughformetobuyherabrandnewphoneinlessthantwoyears.Underthetermsofthisplan,toreceiveareplacementphoneshewouldalsohavetopayadeductibleofabouthalftheoriginalcostofthephone.Wedecidedthatifsomethingdidhappentoherphone,itwouldnothurttoomuchtosimplybuyanewone,sowechosetoretaintheriskourselvesbynotpurchasingthereplacementplan. ExampleofWhenRetainingRiskisNottheBestOption Riskretentiontypicallyisnotthebeststrategyifthepotentialseverityofalossishigh,eveniftheprobabilityoflossislow,suchastheriskofincurringhundredsofthousandsofdollarsworthofmedicalbillsduetolife-threateninginjuryorillness.Whenweretainarisk,wemustbepreparedtofinancethelossourselves. Tryingtoretainhighseverityrisksoftenresultsinlessefficientuseofsignificantresources,suchastoomuchmoneyinaliquidsavingsaccountthatcouldbeearningmoreinotherinvestments.Anothercostassociatedwithretainingriskmayincludelostproductivityduetounnecessarystressandworry.Whenwechoosetoretainriskbutdonotknowforsurewhetherwecouldabsorbthepotentialloss,wemaybecomedebilitatedbyfear. Riskretentioninmoderationcanbeaprudentapproachwhenproperlycombinedwithrisktransfer,intheformofhighdeductiblesoninsurancecoverage.Lowdeductiblescanactuallybeveryexpensivebecausetheytypicallyrequiremuchhigherpremiumswithoutprovidingmuchbenefit.Highdeductiblescansignificantlyreduceinsurancepremiumswhilestillmakingtheimpactoflargelossesaffordable. AdamDawson,CFP®isaPrincipalatCapstoneCapital andtheauthorofTimelessPrinciplesofFinancialSecurity.Ifyouneedhelpdecidinghowtomanageyourrisk,pleasecallustoscheduleafreeconsultation. byCapstoneCapital [Sassy_Social_Share] Searchfor: Categories All Economy Family FinancialGoals Giving Insurance Investing News Relationships Retirement Spending StockMarket SimilarArticles ShouldYouInvestAtthePeakoftheStockMa…Howmuchhighercanthestockmarketclimbbeforethe[…] MeetCapstoneCapital’sNewestWealthA…PleasewelcomeKylePrice,ournewestWealthAdvisor![…] OurThoughtsonBitcoin:CapstoneCapitalWea…Haveyoubeenwonderingwhatexactlyisbitcoin,and[…] FavoriteQuotesOurfavoritequotesonwealthbuilding,financialsecurity,andlifephilosophyfromthegreatestmindsofourtime.[…] Searchfor: Categories All Economy Family FinancialGoals Giving Insurance Investing News Relationships Retirement Spending StockMarket SimilarArticles ShouldYouInvestAtthePeakoftheStockMa…Howmuchhighercanthestockmarketclimbbeforethe[…] MeetCapstoneCapital’sNewestWealthA…PleasewelcomeKylePrice,ournewestWealthAdvisor![…] OurThoughtsonBitcoin:CapstoneCapitalWea…Haveyoubeenwonderingwhatexactlyisbitcoin,and[…] FavoriteQuotesOurfavoritequotesonwealthbuilding,financialsecurity,andlifephilosophyfromthegreatestmindsofourtime.[…]