Risk Management Applied To Personal Finance

With the recent CDO (collateralized debt obligations) crisis, the has been a number of stories about risk management and financial risk management. For some, the concept of using risk management occurs after the issue has happened. However, risk management is best done before the event occurs, in order to prevent significant problems. Here are some of the ways I apply risk management to our personal finances.

1. Avoid high risk - We tend to avoid investments that tout big gains that are low probability or have potential losses that are high probability. Some examples of low probability big gain investments include penny stocks, put or call options, "guaranteed 20% returns, " or "earn $5000 per week doing _____ from home." These examples also tend to be high probability for losing all or part of one's money.
   
   We also avoid exotic debt, such as adjusted rate mortgages, which may risk one's home based on the rise of short term interest rates.



2. Mitigate necessary risk - We try to reduce the impact of stock market declines by putting part of our funds in bonds and CDs. We buy bonds and CDs that have maturities between one and five years to help maintain more stable interest rate returns Finally, within both our stock and fixed income portfolios, we use diversification to improve our return and reduce risk.



3. Insure against debilitating risk - For low probability, but potentially catastrophic events, we use insurance to protect us against the risk. We used to spend about 3.4% of our pre-retirement income on health, life, disability, property, car and long term care insurance. In retirement, we have dropped life and disability, but will be spending about 4.7% of our retirement income on the other insurance coverages.

This approach to risk helps maintain steady growth for our overall family wealth. While we won't have phenomenal gains in any one year, we hopefully won't have any catastrophic losses either.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial or risk management advice. Please consult a professional advisor.

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