The Natural Wealth™ Process (NWP) breaks the Financial Life Planning process into five elements: Vision, Wealth, Tax, Cash, and Risk. The process is designed to work through the elements in 90-day, quarterly focus periods through each calendar year. The exception is Vision. Vision is in constant view through the planning year as it guides choices and actions in each of the other elements. The other four elements, Wealth, Tax, Cash, and Risk are each divided into the following areas sub-elements purposes: Person, Portfolio, and Possessions.
This quarter we focus on Risk, breaking risk down into Person Risk, Portfolio Risk, and Possession Risk.
Before we go any further, it’s important to re=establish exactly what we mean when we discuss risk from a financial life planning perspective. To this end, we will begin with how risk is defined in the dictionary. The Oxford English Dictionary defines risk as:
“(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility”
In the Natural Wealth™ Process, we view at risk as to the “possibility of loss or negative outcome”. With Person Risk, we review, analyze, and address all the risks associated with your physical and mental ability to live life, to work, and enjoy leisure activities and, the impacts on your household’s financial life plan from disability or death. Portfolio Risk encompasses all the risks associated with your investments and, if applicable, your family business assets. Possession Risk, as the name denotes, deals with the risks associated with owning personal assets (stuff!) like one’s home (and, if applicable, a cottage or camp), vehicles, recreational vehicles, and any other personal, non-investment, or business-related assets.
Risk is an inherent part of living life. We experience risk with our health and in our relationships, our lifestyle and pastime choices, our incomes, and our wealth. You pick any situation or set of circumstances in life, there is an element of risk involved. The is really no such thing as a truly “risk-free” situation in life if one considers the situation carefully enough. It is, in short, a fact of life. A wise person considers risk in their decision-making, seeking to understand it and, where possible and prudent, develop a plan to insure against it (having aa “Plan B” of sorts) or acquire insurance in the marketplace to protect ourselves and those around us. There are also situations where we cannot have a plan “B” or insure against risk. In these situations, we must accept the risk full-on.
How serious is a risk? That depends. The answer is to take a long hard look at the fragility of your situation. The word fragility is defined in the Oxford English Dictionary as:
“the quality of being easily broken or damaged”
For our purposes, fragility is the possibility that our financial life plan, indeed, our overall financial well-being, such as it may be at any point in life, is open to being damaged or de-railed by life events, including but not limited to, disability, death, loss of employment, loss of investment or business wealth, loss of reputation, and/or, damage or loss to our possessions.
Understanding fragility requires total honesty with ourselves and the other stakeholders in our life (our spouse, family, business partners, and associates); something the vast majority of people can have a hard time with. It seems easier to “whistle our way past the proverbial risk graveyard”, not daring to look inside!
We need to dig deep, thoughtfully and honestly, answering “What if…” questions. “What if I got seriously ill or was seriously injured in an accident? What if I die (what happens to the financial lives of those closest to me?) What if I lost my job? What if my investment income decreased, or portfolio wealth went down in value? What if my business failed? What if my personal or professional reputation was attacked on social media? What if my house burns down, or my vehicle is totaled in an accident?” The list could go on…
Your answers to these questions will help determine how fragile your financial situation is and, what the most significant dangers and risk(s) might be, not the other way around! This is key to understanding risk and building a thoughtful risk management plan for yourself, your family, your investments (including your business, where applicable), and other assets. For example, if you have a large amount of financial wealth (Portfolio Wealth as we refer to it) and you become seriously disabled, you may still be able to live a financially comfortable life (even if not a physically or mentally comfortable one). Your situation is financially “sound” or “robust” (maybe even "anti-fragile!”). On the other hand, if you have less wealth and more debt, have high living expenses, have family financial responsibilities, have less employment and/or income security, and/or, have a high genetic, lifestyle-related, or employment-related predisposition for disability or death, your situation is fragile. The degree of fragility is dependent on the number of factors and the significance of the factors you are exposed to. In planning, we can determine fragility. We cannot determine with any degree of accuracy if or actual risks might occur.
Most of what we are talking about here we would consider risk capacity or, how resilient and robust your actual life circumstances and financial situation are in the face of various risks. We believe there is a second consideration in personal financial risk management we refer to as “risk tolerance” (sometimes referred to as “risk appetite”) or the psychological ability to take or avoid risks in search of the desired outcome. A lower level of risk tolerance manifests itself as anxiety when contemplating the possibility of a loss (financial or otherwise). A higher level of risk tolerance (emotional resilience) allows an individual to better withstand the psychological impacts of a negative outcome. Higher risk tolerance allows individuals and households to consider more aggressive financial life planning and investment strategies. However, there is a danger for a person who demonstrates a high level of risk tolerance in that they might not take the time to get a clear understanding of the risks involved in some situations. Instead, they try to apply past experiences and heuristics (rules of thumb) that may have worked in other situations, to a situation not previously experienced. The consequences can sometimes be financially painful.
Understanding risk capacity and risk tolerance/risk appetite are essential to determining the ability of the individual, household, or business to achieve their stated goals and objectives. An individual, household, or business may have aggressive goals and objectives (life vision) but a low-risk capacity and/or risk tolerance which will create stress in the financial life plan. It’s important that vision and, risk capacity, and tolerance are congruent or if they are not, that the individual or household understands the implications. Our experience suggests that clients often don’t consider the fragility of their circumstances and the risks that might manifest themselves over the course of their lives. It’s not always natural to admit that we are susceptible to risk. It can be considered (incorrectly) weakness… It’s easier to “whistle past the proverbial graveyard” than it is to acknowledge the fact the “stuff happens” and build provisions into the plan to deal with risks as they appear.
Follow along in the next few weeks as we focus on the element of Risk in the Natural Wealth™ Process. We will break the element down into three kinds of risk facing individuals, households, and businesses: Person Risk, Portfolio risk, and Possession Risk.
If at any time you want to discuss risk as it might pertain to your financial life and investment planning, please call or email us. We welcome all questions and discussions.
David J. Luke, CFP, RFP, CLU, CH.F.C., CIM, RIAC | Financial Advisor
360 Private Wealth Management | Manulife Securities Incorporated
Unit 1 – 25 Scurfield Boulevard, Winnipeg, MB R3Y 1G4
Main Office 204.925.5868 | Direct 204.925.2073| Fax 204.925.2263 | Toll Free 844.688.3656