Personal Risk Classification
Every investment has some risk associated with it. In the personal risk management, we must know how to identify what type of risk we are facing. In this article, we are going to see the major types of personal financial risks.
There are 4 broad classes of risks we may come across. They are Income Risk, Expense Risk, Asset/Investment Risk and the forth is Debit/Credit Risk.
Major Types of Personal Financial Risks
While planning your financial goals, you need to consider the risks related to your income, capital and investments. Prudent investors evaluate their risk tolerance and make appropriate investments in order to assure the achievement of their goals, despite the potential risks that may befall them.
Now, lets discuss major type of risks on your financial plan and how to avoid, share or transfer such risks. We will be looking at the following types of personal risks:
This type of risks is directly related to your ability of earning an income. Thereby resulting into the loss of income, due to the following reasons:
- Disability and therefore unable to work
- Losing of the job
- Under-employment, due to which you are unemployed
- Outliving the income produced from the assets, from the aging perspective (specifically, for retirees cases)
Methods to manage the Income Risk
There are majorly two ways of managing the income risk, such as avoiding the risks and transferring of such risk. Let’s see, how?
1.Avoid the risk :
- For avoiding the risk, it is very relevant but it is not always possible to have the multiple alternative income streams like spouse income, part-time blogging/freelancing, etc. Also, it is very important to make the proper career management for continuous learning in order to help mitigating the risk of unemployment and under-employment (as the case may be).
- Proper retirement planning, frugal i.e. economical living and annuity planning is very crucial, to reduce the chances of outliving the assets producing the income.
2.Transfer of risk :
- Proper level of life insurance coverage must be taken in order to ensure that the surviving family members could maintain the same lifestyle, in case you die.
- Disability insurance can be taken, for easing the financial pain, in case you become disabled.
Expense risks are the risks, which may occur due to the following reasons:
- When you spend more money, than you earn
- When you are not earning enough, to meet your needs
- When you have the emergencies, that forces you to spend money
Methods to manage the Expense Risk
In order to manage the risk, one may manage it by avoiding such risks or by transferring it. Let’s see, how?
1.Avoid the risk:
- For avoiding the expense risk, one can in order to curb the expense practice budgeting. It helps to lower your expenses. One can follow, the India specific rule 50/30/20 for understanding the non-relevant expenses.
- Learn how to earn the extra income, so that you could earn more than the amount you spend.
- Start an emergency fund so that you have reserve cash to deal with emergencies i.e. contingencies. For further details, please refer our articles ‘Contingency Planning – An Overview’ and ‘Contingency Fund – How to Manage?’ on
2.Transfer of risk:
- For planning of the expense management, one can take the proper insurance policies such as car insurance, home insurance and umbrella insurance, to ward against the major tragedies.
Your assets include both your investments and other assets, such as your house, cars, jewelleries and other possessions. Unfortunately, they all are vulnerable to various kinds of risks, including the following:
- Not saving enough or having the right investment, to meet your financial goals
- Not having the right investment mix for the goal you’re trying to accomplish
- Losing your investment (principal)
- Sub-par return on investment
- Under-diversified or un-diversified investment portfolio
- Theft or destruction of your properties
Methods to manage the Asset/ Investment Risk
In order to manage the asset or investment risk, one may again avoid it or transfer it. Let’s see, how?
1.Avoiding the risk:
- Ensure that you save enough for your financial goals. For which you need to create a Financial plan and review it regularly.
- Learn about the risk and return characteristics of each asset class and choose the right investment mix for each financial goal.
- Learn about the capital preservation characteristics of each investment type.
For Example, your money is relatively safe in your savings account, CD (certificate of deposits), money market, and treasury — but the trade-off is mostly/ relatively at the lower rates or return, possibly lower than the inflation. On the other hand, you could lose it all with the stock market, small business and the real estate — but the returns on investment are potentially higher.
- To reduce the diversification risk, one must the understand the concept of investment correlation and diversification. It helps in reducing the overall volatility and risk of your overall investment portfolio.
- To reduce your depreciation risk, avoid spending money on assets than do not gain value over time. The most obvious examples are automobile, designer jewellery and electronics. These items are 99.99% guaranteed to lose value over time.
- Inflation is a constant force that erodes your purchasing power with time. The only way to protect yourself against inflation is to choose investments that can beat inflation. That means such investments increases its value in tandem with inflation, such as Fixed Deposits, Debt Instruments, Debt Funds, precious metals, commodities, etc. However, the investments which has the potential to beat inflation are stocks, mutual funds, ETF (Exchange Traded Funds), Real Estate, etc
2.Transfer of risk :
- Protect your physical assets against theft or destruction with appropriate types of insurance.
- For Example, Home insurance, car insurance, business insurance, etc. Moreover, limit your personal liability with an umbrella policy
4.Debt/ Credit Risks
Debt/ Credit Risks are the risks, which may occur due to the following reasons:
- Accumulating of too much debt
- Accumulating bad debt instead of good debt
- Spending too much money on debt related expenses such as higher interest rates, finance charges, etc.
- Bad credit
Methods to manage the Debt/ Credit Risks
In order to manage the these Debt/ Credit risks, one may avoid it. Let’s see, how?
1.Avoiding the risk :
- We all know that too much debt is bad and we should try to avoid debt as much as possible.
- Learn the difference between good debt and bad debt and avoid the bad ones. Good debt are the debt which builds an appreciating asset such as Home Loan, Education Loan and Business Loan, etc. Bad Debt are other forms of debt like Personal loan, Credit Card loan, Car loan, etc.
- If you’re already in debt especially the Bad debt, pay down your debt as fast as you can, to reduce the debt related expenses. Go with the rule, that your overall expenses including the essentials such as household and wants such as lifestyle, debt, etc. shouldn’t be more than 50% + 20% of your income.
- In India, it is a normal practice to give credit to others and earn a good interest on it. This is a very risky exercise and more often this can turn out to be a bad credit. It is always better to avoid this.
- Credit Score is becoming an important parameter to get a new loan and it is important that you keep a track on it and improve it for easy and cheaper loans.