I grew up in Oklahoma. My first memory of storms was as a preschooler. My mother took us to see her parents. We drove through a storm. The next day we learned that the storm had generated a tornado nearby that had done some damage. I understood from the way the grownups were talking that this was serious business. I learned to respect storms.

Each day we each face manifold risks. Understanding probability of the risks and their impact on your life is one key to developing a plan to manage them. Risk is defined as “the exposure to the chance of injury or loss”. Developing a risk management plan hinges on two components of this definition—exposure and chance.

Although the probability is relatively remote, your exposure to the risk of a tornado is greater if you live in Tulsa as opposed to Honolulu. You can manage your exposure by your choice of where you live. Chance is the likelihood that something will happen. Once you choose to live in Oklahoma the frequency of tornadoes should inform your choices of your type of dwelling, safety precautions and disaster planning.

What does this have to do with financial planning? Risk is your exposure to events that could happen in the future. Your choices can expose you to certain risks or protect you from them. For example: death. The probability of death is one to one. Everyone will die. The risk is in when it will happen. The economic impact of an untimely death, however remote the possibility, creates serious financial risk to those who are dependent. That family can choose to retain the risk, “It will never happen to me!”, or shift the risk, “Honey, we need to buy some life insurance!”

The market collapse of 2008 brought us all face to face with the reality of investment risk. It was like a real life horror movie, except there were no actors and the victims were looking back at us from the mirror.

We all want to have an investment that gives high returns with no risk. Bernie Madoff made a lot of money convincing smart people that he could give them just that. The relationship between risk and reward are a direct correlation. No risk—small reward. Bigger risk—you have a greater possible reward and greater potential for loss. Knowing your comfort level for risk is ground zero for these choices.

There are defensive measures in investing that can be added to a program to limit downside risk. None are perfect and often there is an expense, but any time you shift a risk there is an expense. A simple cost-benefit analysis will help you determine if the strategy is right for you. Insurance companies understand the benefit of shifting risk. They serve an important function in your financial plan.

So how do you deal with risk? Risk is defined as “the exposure to the chance of injury or loss”. Applying logic and simple statistics to your decision making process can guide you to good choices. For instance, what is probability of your house burning down this year? That risk is only about 1 in 300. If the cost of fire insurance is $1000 per year and your house is worth $300,000, that cost is identical to the risk or .3%. Writing the check for $1000 is much easier than the risk of writing one for $300,000. It makes sense to shift that risk to the insurance company.

Other risks are not always that simple to quantify, but you can do it. The Axiom Advisors “What-If?” simulator can help. Our advanced planning tools can simulate a risk and show you the potential impact. This makes the cost-benefit analysis much easier to process.

Shifting risks that could impede your success and retaining those you can afford to keep is never easy but is possible. It is better to do the “What if?” before hand than to be left with the “If only..” afterwards.

Submitted by David M. Wheat, CFS, ChFC

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