We have a lot of fun planning for major events like weddings, college, and travel.
But a complete financial plan also needs to address when the unexpected happens. Simply put, we need to plan for emergencies. For example, you may face a temporary job loss or transition, a downturn in the stock market, or even a critical illness. Left unprepared, these types of events can derail your financial plan and can have a significant impact on your finances.
The first step is identifying the types of emergencies or risks there may be to your financial plan. Your risks will be unique to your situation, goals, and lifestyle. The risks facing a young married couple with children are very different than a recent retiree.
The second step is to evaluate the likelihood of something happening. Is it highly likely that this event will happen? What is the impact if it does? If you are close to retirement, a job loss may not be ideal, but it may give you an unexpected head start into retirement. Conversely, if you are planning to work another fifteen years, a job loss could have a bigger impact on some of your goals and lifestyle.
Now that we’ve identified the risks and categorized their probability and impact, we need to address them. We have four ways to mitigate risks:
- Avoid– Some risks can be avoided. If you need money in the near future for a goal, we can avoid stock market risk by investing in a money market fund or CD.
- Reduce– We can mitigate some of the risk by reducing the impact or likelihood of something happening. By diversifying your investments, you can minimize the impact of poor performance by one company or sector.
- Transfer– In some cases, it may make sense to transfer the risk to a third party. For example, if you need to cover expenses for loved ones in the event of your death, a life insurance policy transfers this risk to the insurance company
- Accept– If you have a low probability, low impact risk you may decide to accept it and do nothing. For example, if you have a stable job, sufficient savings and are close to retirement, you can accept the risk of potentially losing your job.
A sound risk plan is a foundational part of making sure your goals and lifestyle aren’t impacted by the unexpected.
