Three Fundamentals of Risk Management

Three Fundamentals of Risk Management

Risk management, the process of identifying the greatest sources of risk in an investment strategy and finding ways to minimize them, is crucial to your financial health. You regularly practice risk management subconsciously in other areas of your life. Every time you look before crossing a busy street or buckle your seat belt, you have identified common sources of risk and acted to mitigate them. Making those same sound decisions financially, though, doesn’t always come naturally. Understanding and codifying the process of risk management is at the core of what your CPA does for you.

From an accounting point of view, risk management falls into three broad categories: elimination, retention or transfer of risk.

Eliminating Risks

Streamlining your portfolio by trimming unnecessary investments is a sound risk management strategy built on risk elimination. When you no longer have an asset to maintain, you negate all risk associated with it. For example, property that you own requires investments in insurance, upkeep and taxes, among other expenses. Sometimes those costs are worth your investment; you would certainly choose to keep a lucrative rental property that more than paid for itself each month. Other investments are less clear-cut. Raw land that may appreciate in value as a neighboring metropolitan area grows is a more significant risk and may be a candidate for removal from your investment portfolio.

Your financial advisor can work with you to locate risk sources that are a poor fit for your financial strategy and help you find ways to realize a return on those investments.

Retaining Risks

In some cases, a certain amount of risk is not only unavoidable but desirable. When you choose to acknowledge a risk and shoulder the potential costs yourself, you opt to retain the risk. Buying shares of a stock that has been volatile in the short term but shows an overall upward trend in the long term is an example of risk retention that can work in your benefit if you make the stock part of your long-range planning. In the previous example, a parcel of raw land may be a risk worth retaining if new home building rates in the area are trending upward and are expected to continue for the next few years.

Risk retention is somewhat of a risk in itself, but a thorough understanding of the potential costs can make it the right decision in some cases. It is not always an option, though, and your financial advisor should make you aware of the cases in which it isn’t. You might decide to opt out of company 401(k) plans, but you cannot decide to forgo taxes.

Transferring Risks

Somewhere between divesting yourself of risk and retaining the full measure of it is a risk transfer strategy that splits any risk between you and a third party or parties. The best example of transferring risk is insurance. By paying health insurance premiums, for example, you place some of the potential cost of an illness or injury on the insurance provider’s shoulders. Risk transfer is a more nuanced possibility than risk elimination or retention. You can choose to transfer only part of your risk, paying smaller premiums in exchange for a higher deductible or less complete coverage, or you can transfer more of your risk with comprehensive plans.

With that increased flexibility comes a greater need to understand what risk transfer means for your investment portfolio. Insuring art, collectibles, property and other assets is crucial to long-term financial health, but it’s possible to provide too much financial protection. Work with your CPA to find the risk management strategy that fits your needs.

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