Worried About Your Money? 3 Strategies to Help Reduce Financial Risk

We encounter risks daily, from driving to work to making financial investments. Just as you might choose to manage driving risks by wearing a seat belt, you can manage financial risks through strategic planning. Financial risks, such as investment losses, inflation, and the possibility of outliving your savings, are inherent. Understanding and managing these risks effectively is crucial for financial stability.

Here are three strategies to help you mitigate financial risks and safeguard your financial future.

1. Avoiding Investment Risk

Avoiding investment risk often means opting for safer, more stable investments, but this typically comes with lower potential returns. While it might seem attractive to avoid risk entirely, especially in volatile markets, this approach can have its own drawbacks.

Safe Investments:

• Savings Accounts: FDIC-insured savings accounts offer security up to $250,000. However, with current low interest rates, the returns may not keep pace with inflation, leading to a gradual erosion of purchasing power.
• Certificates of Deposit (CDs): CDs are another low-risk option, providing fixed interest rates over specified terms. While safer, the returns are modest.

Zoey Lin, Vice President in Financial Solutions at Fidelity Investments, emphasizes the hidden costs of avoiding investment risks. “When people are afraid of taking investment risks, the pursuit of their personal dreams can become more challenging,” Lin notes. Without sufficient growth in your investments, funding significant future expenses like your children’s education, a dream home, or a comfortable retirement may become difficult.

While avoiding risk can protect your principal, it may limit your financial growth. It’s essential to balance safety with potential returns to ensure you can meet your long-term financial goals.

2. Managing Investment Risk

Managing investment risk involves strategically diversifying your investments and making informed choices to balance potential returns with acceptable risk levels. Here are four common strategies:

1. Fixed Income: Investing in high-quality fixed-income products, such as Treasury bonds or investment-grade corporate bonds, can provide a stable return. While bonds come with risks like interest rate and credit risk, they generally offer lower volatility compared to stocks.

2. Asset Allocation: Diversifying your portfolio across different asset classes (stocks, bonds, and short-term investments) can help manage risk. Historically, stocks offer higher returns but come with greater volatility, while bonds are more stable but with lower returns. Setting a mix that aligns with your investment time frame, financial needs, and risk tolerance is key.

3. Asset Location: Placing investments in tax-advantaged accounts can reduce your tax burden. Hold highly taxed investments, like taxable bonds and short-term stocks, in accounts like 401(k)s and IRAs. Investments taxed at lower capital gains rates can be held in taxable brokerage accounts, optimizing your after-tax returns.

4. Tax-Smart Withdrawals: In retirement, strategically withdrawing from different accounts can reduce tax liability and extend your savings. Start with taxable accounts to allow tax-advantaged investments to grow, enhancing your overall financial longevity.

For those uncomfortable managing their portfolios, consider a target risk fund or a professional advisor. Robo-advisors can also tailor asset mixes to your goals and risk tolerance, often at lower costs.

3. Transferring Personal and Investment Risk

Transferring risk involves shifting the financial burden of potential adverse events to another party, usually through insurance. Here are some common ways to transfer both personal and investment risks:

Personal Risk Transfer:

• Homeowners Insurance: Protects against risks associated with homeownership, such as damage or liability.
• Long-Term Care Insurance: Covers the high costs of extended care, like nursing home residency.
• Umbrella Liability Insurance: Extends coverage beyond home and auto insurance, protecting against significant claims or lawsuits.

Investment Risk Transfer:

• Pensions: Employers often transfer pension payment responsibilities to insurance companies, ensuring a stable retirement income for employees.
• Income Annuities: Purchasing annuities can provide a guaranteed lifetime income, transferring the risk of outliving your savings to an insurance company. Options include immediate or deferred annuities, with various riders to protect your principal or ensure minimum income levels.

Annuities with riders can offer additional benefits, such as guaranteed lifetime withdrawal or accumulation benefits, further mitigating financial risks.

The Importance of Having a Strategy

When the market becomes volatile, sticking to a well-thought-out plan is crucial. A disciplined investment strategy, reflecting an appropriate asset mix and risk tolerance, can help you navigate market turbulence and personal financial upheaval.

Key Takeaways:

• Know Your Risk Capacity: Assess both emotional and financial aspects of your risk tolerance. Understand how much loss you can afford and tolerate in pursuit of long-term growth.
• Plan Ahead: Use the Avoid/Manage/Transfer framework to develop a comprehensive risk management strategy.
• Seek Professional Help: Consider working with a financial advisor to tailor a plan to your unique needs and goals, ensuring you receive good value for the fees you pay.

By understanding and applying these strategies, you can effectively manage financial risks, ensuring stability and growth in your financial journey. Remember, balancing risk and reward is essential to achieving your long-term financial goals and maintaining peace of mind.