By FPA member Rick Miller, CFP®

Last Updated: February 15, 2010

Understanding the nature of risk is the first step to managing it. Very simply, risk is unpredictable damage to your assets. The table below lists some important examples. 

When trying to manage risk, you can choose among four key strategies:

1. Avoidance — you can choose not to take the risk by not owning the asset.
2. Mitigation — you can reduce the risk.
3. Insurance — you can pay others to share the risk with you.
4. Acceptance — you can bear the risk yourself.

The risk management strategies you choose for each area will depend upon your assessment of the importance of each risk (and potential damage) to you and your family, and on the resources you choose to apply. Just a quick look at our risk table and the list of strategies should convince you that it would take a long time and more space than we have here to consider every strategy for every risk. However, we can consider every asset category, and discuss the most important strategies for each one.

Human Capital (Earning Power)

Thinking about your ability to generate income as an asset is a relatively new idea. It is important, however, because human capital is the largest asset for many younger people and couples. It should be immediately clear that you can't avoid risks to your human capital — you have to own it!

Mitigating death and disability risks is an excellent strategy — following your doctor's advice for good health (eating healthy foods, exercising regularly, not smoking, maintaining your weight, managing stress, getting enough sleep) also significantly reduces your human capital risks. And, it's not expensive! Most people find that if they eat right, they enjoy life more — and eating healthy food costs no more than eating unhealthy food. Also, regular exercise can cost very little, stopping smoking saves money, etc.

Staying healthy isn't enough, however. Accidents do happen. This is where insurance comes in. Life insurance can help your loved ones replace your income should you die prematurely. Long-term disability insurance can (partially) replace your income for you and your family if you can't work. Importantly, following a mitigation strategy can reduce your life and disability insurance costs! Life insurance and disability insurance are less expensive for healthy people because their chances of premature death or illness are lower.

Unemployment is another risk that you can address both by mitigation and insurance. Unemployment insurance is provided by both state and Federal governments, and you don't even have to buy it.

But how can you possibly reduce the risk that your employer will fire you or lay you off? Doing a good job for your employer makes you more valuable, and at less risk of layoffs. That's easier to do if you enjoy your work and are good at what you do. So, choosing work that you enjoy is a risk reduction strategy. In addition, if you enjoy your work, you are more likely to keep your skills current and your professional network strong. Then, if you do lose your job, it will be easier to find another.

Financial Assets

Your financial assets represent your savings — you don't spend resources when they arrive so that you can spend them later on college, or to support your retirement living standard, for example.

The forms in which you hold your savings largely determine the risks you will face — the risks to bank deposits and stock holdings are different in character and in severity. That suggests that your most powerful risk management strategy for financial assets is avoidance of the high risk forms. Safer asset classes include bank deposits (insured by the U.S. government) and Treasury Inflation-Protected Securities (purchasing power guaranteed by the U.S. government). Riskier asset classes include stocks and corporate bonds, especially risky high-yield or "junk" bonds.

It is true that higher risk assets offer higher returns. You must decide whether the extra return justifies the extra risk. One approach is to minimize risk for the assets that you cannot afford to lose, and accepting more risk and the potential for higher return for the assets that you could, in a pinch, do without.

In general, insurance for financial assets is expensive, and the expense may be large enough to negate the return advantage.

There is one case where insurance is well worth considering. Once you have retired, perhaps your greatest financial risk is outliving your assets. You can insure against this risk by annuitizing — using some of your assets to buy an income stream guaranteed for as long as you live. You can insure against a decline in purchasing power by buying an inflation-adjusted annuity.

Real Assets

You've probably thought more about managing the risks to your home and automobile than any other. And, you may well have insured them — homeowner's insurance, auto insurance, etc. In many ways, circumstances require you to insure this property. For example, mortgage lenders require that you maintain homeowner's insurance, and most states require that you carry auto insurance. You can add a layer of protection against a lawsuit by purchasing "umbrella" insurance — a frequently overlooked option that can protect you against liability for accidents that you cause.

Importantly, you can also mitigate risks to your real assets. At home, you can invest in smoke detectors and fire extinguishers. On the road, various automobile safety features and defensive driving courses can reduce your risk of loss.

Social Assets

Risks to your social assets are hardest to manage. You can't avoid them or mitigate them, and you can insure them only by developing social assets in other jurisdictions (say by obtaining citizenship in another country). Because you have no choice but to bear these risks, it is prudent to ask how you would respond if they were to materialize. Fundamentally, this would require adapting to smaller income if Social Security were to reduce its payments, or finding alternative medical coverage if Medicare or Medicaid were to reduce benefits. Because you'll be relying on these benefits later in life, the only way to adapt is likely to be drawing on your own extra resources, and perhaps selling your home in order to access and use your home equity. It is a disturbing prospect, but the more cushion you have, the better you'll be able to adapt.

Summary and Conclusions

So, how should you change your approach to risk management? A corporate risk manager will assess all of the risks facing the company, and then focus on limiting the potential impact as much as possible at the lowest possible cost. That means:

• Avoiding unnecessary risks — this costs nothing.
• Mitigating risk if it costs less than buying insurance.
• Insuring remaining high impact risks — the ones that threaten survival, and for which insurance is available.
• Bearing only risks that can't be avoided, mitigated or efficiently insured.

You can apply the same approach for your family. And remember, the corporate risk manager doesn't try to do it alone. You can consult with experts, too — your doctor, your financial planner, your insurance broker(s) and your investment adviser. Especially with your financial planners, an annual discussion of risk management can help you adapt to changes in your situation.

Find a financial planner.

FPA member Rick Miller, CFP®, is the founder of Sensible Financial Planning. In 2009, Rick served on the Trends in Financial Planning and Job Analysis task forces of The Certified Financial Planner Board of Standards. He is a strong advocate for the Life Cycle Planning and Investing approaches within the profession, and frequently conducts professional seminars on those subjects. He earned his Ph.D. in Economics at the University of Chicago. His studies included family economics and lifetime planning.