With the heightened volatility in the financial markets this year, the subject of risk and risk management has taken on greater emphasis. A prominent risk for most of us is financial risk. Risks to our finances can come in several forms such as an unexpected large expense, an unexpected change in our health, or an unexpected or material change in our assets. One of the best ways to mitigate financial risk is through financial planning. Financial planning acts almost as a form of “insurance” that helps us better position for unexpected events.
One of the ways in which financial planning reduces financial risk in our lives is the planning process itself. For example, an important step in constructing a financial plan is gathering detailed information on one’s expenses. Many times this can be a tedious process, but in the end it provides the client with a better understanding of their spending. This improved understanding of expenses can lead to pathways to better management of one’s expenses and thereby improve one’s cash flow.
Another way financial planning can reduce risk is through contingency planning, or planning for emergencies or the “unexpected” large expense. Good financial planning will involve running several scenarios that can incorporate a variety of specific financial goals or financial events. To the extent contingencies are incorporated in a financial plan, one can determine how best in financial terms to prepare for the contingency, such as setting aside funds to “insure” against the event. This leads not only to better financial management but also improved peace of mind.
Financial planning can also help to reduce investment risk through better discipline. A good financial plan should include an investment strategy that is optimized to enable the client meet their financial goals with lower investment risk. The discipline of having an appropriate asset allocation (i.e., the mix of stocks, bonds, real estate, etc. held in one’s portfolio) and sticking with that allocation through market downturns has shown to improve long-term investment returns. This is because it obviates the urge to attempt to “time” the market (i.e. trying to sell at the “top” and get back in at the “bottom”), which has been proven to be not only virtually impossible to do but is also a big destroyer of portfolio returns.
A problem that most traditional financial plans suffer from is that they plan for the financial side of retirement but do not plan for the non-financial components and risks that can derail a retirement. For example, a health problem can become a housing problem when one can suddenly no longer live at home, which can lead to family stress. Our firm recently introduced longevity planning to work in conjunction with our clients’ financial plans. This involves analyzing and incorporating all the elements of later life planning into one integrated plan that addresses family, health, and housing issues in addition to traditional financial and estate planning. This can reduce risk by having planned in advance and mapping out a specific action plan for late life events.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.