When you’re in a mood to indulge in financial planning, it’s extremely important to know the attached risks of it. Let’s quickly understand the gains & losses of your financial decision. When describing a portfolio, we can underline two types of risk:
Good risk which gets compensated with high expected returns.
The bad risk for which you don’t receive any compensation at all.
It’s definitely not a good idea to focus all your stock investments in a single sector/country. Most economic & geopolitical risks can be spread out by investments in a diversified portfolio. Obviously, if you don’t earn higher expected returns in a single go, why wouldn’t you diversify that risk?
Additional Reading on Portfolio Diversification
There’s always a balanced payback for diversified investments, so that risk is traded off against rewards. For e.g. stocks have greater risk quotient over bonds. So, it’s great to have a mix of both.
Types of Risk in Financial Planning
- Longevity risk. Just working on an investment plan is not good enough to ensure it returns the favor in the long-term as well. There’s a high probability that we will rely purely on your assets to make a good living. Thus, investing in stocks along with bonds can help in high allocation to a diversified portfolio. This will substantially reduce the risk of financial losses in the long term.
- Liquidity risk. Investments with high expected returns are difficult to be traded & cashed easily. And liquidating them will charge you a lot of money. So, here you should have a basket of financial instruments to share the load of immovable financial means. In case of emergencies, you’ll be stuck with illiquid assets & pay price for collecting cash. As prudent investors, you must plan your investments in a way to keep liquidity alive & keeping sufficient assets in stock.
- Inflation risk. Individuals who earn a fixed income are considerably affected by the rate of inflation. When the prices of goods go up and their incomes remain the same, then they are stuck with tough budget cut decisions. Under this situation, you must pre-plan to buy bond investments & control the increasing need for liquid money. One can also consider an allocation to commodities which usually performs well when inflation is rising.
- Life event risk. It’s extremely important to have life insurance as a part of the financial equation. Your investments shouldn’t be scaled in a manner that disturbs your financials in the later future. Work on a detailed financial plan which explains & analyzes the financial risks in real-time.
The following insurances can conveniently take care of life event risks:
- Life insurance is taken to reduce the income lost with the death of the job holder
- Disability insurance when the breadwinner becomes handicapped or alike
- Long-term care insurance is used to cover against draining costs of assets
- Property insurance can be used to protect your homes, cars, etc against natural calamities like floods and earthquakes
- Personal liability insurance is an all in all umbrella (excess liability) policy
To sum it up, it is inevitable to build a well thought out financial plan & take consideration of all the risks that could upset it.