After you develop your Savings Plan, the next step toward building generational wealth is to manage your risks. For those that have every played sports, we constantly hear the cliche, “Defense wins championships.” While this is way over-simplified, there is some truth to it. In order to be successful, a sports team usually needs to have a decent offense and a decent defense. The same applies to building generational wealth. I would consider Step 5, building a Savings Plan, to be the offensive part of our generational wealth planning. Step 6, which we will dive into today is all about the defensive part of our generational wealth planning. Both are equally key to successfully building generational wealth.
Why is it important to manage risks?
Managing risks is important because, no matter how well we save for the future, life can be unpredictable and can hit us quickly. There are so many risks in the world, from crossing the street, to skydiving. We can’t manage every single risk, because the truth is, we can’t even imagine all the potential risky situations we might be in during our life. There are a few common and large risks, however, that every person on the road to building generational wealth should consider.
These days, many risks can be managed through insurance, but even buying insurance takes some personal initiative to know that you have an unprotected risk in your life. It also usually costs money, which not everyone is willing to pay. Insurance is not a tangible asset, so it’s hard for many to spend a significant amount of money on something they cannot see or on something they may never see the benefits from. From my experience as a financial planner, I have seen the benefits of different kinds of insurance firsthand, and I can tell you that it is usually worth the cost, though not always. There is certainly no need to buy insurance for something with almost no chance of happening and that would not be too costly.
In my experience, I have also seen that to many people, insurance seems expensive at first. At first, it just looks like another big bill. However, I believe it’s reasonable for people to spend 5%-10% of their wealth in order to protect the other 90%-95%. In fact, this is essential if your goal is to build generational wealth. If an unexpected risk occurs causing you to deplete your personal wealth, the effects of that will undoubtedly trickle down to the next generations.
How do I manage risks?
When it comes to risks, there are three approaches to managing them. You can either take on the risk, avoid the risk, or outsource the risk. The way you manage your risk depends on the risk and also your personal attitude about risks.
Your first option is to take on the risk or “assume” the risk.
Typically, you will do this for a risk when the downside is not catastrophic. For example, if you gamble, you might be willing to take on some risk, but only with minimal downside. So, you might gamble a small sum of money. You might be perfectly fine putting $20 on red on the Roulette table, because if you lose, you’re only out 20 bucks. You might not feel the same way if you put $20,000 on red instead.
You might also take on the risk if it is impossible to either avoid or outsource. For example, if your family depends on your income, there is a risk of you passing away and not being able to continue providing that income. While some may use life insurance to protect against this risk, life insurance isn’t available for everyone. If you have an illness yourself, you may be uninsurable, therefore forcing you to take on the risk. If you end of having to assume your own risks, just make sure you have a plan to do so. In this example, maybe you should save the money you would have spent on insurance into a savings account that can be left for your family if something were to happen.
Lastly, you might also take on the risk if you have a high personal tolerance for risk. For example, if you buy a new computer, you might decline the warranty because you are simply willing to take the risk. This is a very personal decision, and I would encourage people to avoid taking unnecessary risks. But, if the risk is simply not a concern to you, it’s probably not worth paying the cost. If you go this rough, proceed with caution and be willing to own the potential consequences.
The second option to manage risk is to avoid the risk completely.
Typically, you will do this when it’s easy. For example, the easiest way to avoid the risk of riding a motorcycle is to simply not ride that motorcycle. If you want to avoid the risk of getting injured during pick up basketball, try swimming instead. The decision to avoid risk or take on risk can depend on your personal lifestyle. Personally, I love playing pick up basketball with my friends, and am willing to take on the risk of injury to play. For others, it might not be worth it. In addition, each person’s decisions around taking and avoiding risk can change over time. Right now, I am relatively young, and the risk of injury (while certainly there) is not as severe. When I’m 70 years old, however, I probably won’t be making the same decisions. I’ll probably avoid the risk of a basketball injury by watching my grandkids play instead of playing myself.
You might also avoid the risk if you cannot outsource risk and the risk is too great to bear. For example, if you have a poor driving record and cannot qualify for car insurance, the risk of driving is severe. Not only are you breaking the law and exposing yourself to a potential fine, but you are also taking on the risk of having to pay for all of your own car repairs if something unexpected happens. In this scenario, you cannot outsource the risk, but the risk is still very large. Therefore, it would probably be smart for you to avoid driving. Maybe you can hire a driver, ask a family member, or use more public transportation instead.
My suggestion is to avoid risks whenever it’s easy, but don’t let your mission to avoid risk negatively impact your lifestyle. Don’t be that person that doesn’t leave their house because there is just too much risk in the world. Decide which things are important to you and which things are worth taking on risk for.
The last option for managing risk is to outsource the risk. This is often where insurance comes into play.
Typically, we do this for our biggest risks. Think about the biggest assets most people have: their income, their health, their home, and their car. These are the types of things that are the most important to protect. This is because the risks associated with these items can be incredibly costly. Losing your income can cost you millions. Losing your health can cost you your job which can cost you millions. Home repairs can cost 100’s of thousands of dollars, and car repairs can cost 10’s of thousands of dollars. These can be devastating to your progress toward generational wealth. You can have the best Savings Plan in the world, but if you lose your income, what good is that going to do?
Because these types of risks are so great, as a society, we have developed organizations called insurance companies to protect against these risks. Essentially, insurance companies allow us to outsource our risk over to them for a price, usually called a premium. Insurance companies compete with each other for business which usually leads to competitive rates based off of supply and demand. It is important to remember, however, that most insurance companies are for profit organizations. Their goal is to generate more business and get more people to pay premiums. With that, sometimes we get marketed insurance that we might not need. Certain types of insurance where the probability of paying out are so small or where the risk is not that severe are not always necessary. So, while insurance is very important in some areas, beware of being sold insurance that you don’t need.
I would suggest outsourcing risks whenever it is reasonable and when the downside is too large for you to bear. For example, if you may need Long Term Care in the future, but paying for it would deplete all of your money, then you should look into Long Term Care insurance. Insurance companies are specifically created to pool many people’s money together to manage large risks that an individual household might not be able to take on by themselves. Don’t let premium payments keep you from paying your bills or living your ideal life, but when you can fit them into your budget, buying insurance is usually a wise investment in creating future generational wealth.
What are the main financial risks to manage?
There is a lot of risk in the world. There is health risk, emotional risk, family related risks, career risk, and many more. Many of these types of risk are outside the scope of this book, but I wanted to focus on the 4 main financial risks that are important to manage when striving for generational wealth.
Risk #1: Loss of Income
One of the biggest financial risks we face is the risk of losing our income. This is a huge risk, especially if you consider how much in income you might earn over the next 20+ years. Losing out on that would be costly! The main ways we could lose our income are by losing our job, becoming disabled and not able to work, or by passing away.
To mitigate against the risk of losing your job, it’s important to maintain your Emergency Fund of 3-6 months expenses. This will allow you 3-6 months to find a new job and start earning income again.
To mitigate against the risk of losing your income due to disability, you should look into both short term and long-term disability insurance. Short term disability will typically pay you income if you have a temporary disability (less than one year). Long term disability will typically pay you income until retirement age or longer if you have a permanent disability (more than one year).
To mitigate against the risk of losing your income due to passing away, it’s important to consider life insurance. Life insurance pays a tax-free death benefit to your family when you pass away. This can make up for the income you would have produced if you were still alive. Often times, life insurance is provided through your job, but it’s almost never enough to truly replace your income. I would recommend working with a financial planner that is insurance licensed to help you determine the proper amount and type of life insurance for you.
Risk #2: Major expenses
Another large risk we face is the risk of an unexpected major expense. This is where things like car repairs, home repairs, and medical events come into play. Any expense that would be more than what we have in our emergency fund, should be covered by insurance. For these areas, you need to have car insurance, home insurance, and health insurance. Fortunately, many of these types of insurance are legally required, so there is some extra incentive to protect against these risks. It’s also important to look closely at your policies to make sure the out-of-pocket payments aren’t larger than what you have saved in your emergency fund.
Risk #3: Inflation
Inflation is one of the biggest risks that we never think of. Inflation is defined as the constantly rising costs of goods and services. Historically, inflation averages between 2% and 3% per year. When we are talking about it as a risk, we are talking about the risk that our money will not be as valuable or useful in the future as it is right now. To mitigate the risk of inflation, we need to make sure that any money we have saved for the future is in a place to outpace inflation. Historically, stocks, bonds, and real estate are some of the only assets that consistently outpace inflation. For example, if I am saving for retirement in 20 years, I should not keep my money in a savings account earning 1%. This will actually cause me to slowly lose out on purchasing power over time. Instead that money should be invested somewhere that has good potential to keep up with and hopefully outpace inflation.
Risk #4: Market Volatility
The last major financial risk that we will discuss is market volatility. If you are successfully mitigating Risk #3: Inflation, then you are probably investing in either the stock, bond, or real estate market. While over the long term, these areas provide somewhat predictable returns, in the short term there can be significant volatility. To mitigate against market risk, there are two main concepts to consider: Time Horizon and Diversification.
First, you have to invest with your time horizon in mind. The shorter your time horizon, the less risk you should take on. For a goal that occurs within the next couple of years, you should not take on much risk at all. For a goal that occurs in 20+ years, you can afford to take on more risk. If you are careful about investing with your time horizon in mind, you can usually avoid having to liquidate from markets when they are down.
Diversification is also crucial to mitigating market risk. This is the classic idea of not putting all of your eggs in one basket. Don’t invest everything you own into one asset class. Diversify. If you are investing for the long term, don’t just invest in one stock, invest in a mutual fund or an ETF that contains over 100 stocks. If you are investing in property, don’t put everything you have into one home. Instead, develop a real estate portfolio with multiple investments or invest in a REIT that invests in multiple properties. Diversifying will prevent you from experiencing serious losses if one asset class underperforms.
Final Thoughts
Managing risk is essential to creating generational wealth. I would recommend taking some time to assess the top 5 risks in your life and to make sure you have a plan for them. Your plan could be to take on the risk, avoid the risk, or outsource the risk. The important thing is that you have a plan. I would suggest looking into insurance for the biggest items. Outsource risk whenever the downside is too great for you to handle. Lastly, I recommend working with a Certified Financial Planner to help you with a risk mitigation strategy. Managing risk is a key pillar to a CFP’s training and they can help you think of potential risks and put together a plan to mitigate your biggest risks.
This blog post is a rough draft for Chapter 6 of 10 for my Step-by-Step Guide for Building Generational Wealth. For now, each step will be in the form of a monthly blog post. I really hope to get your feedback and thoughts. After finishing the step-by-step guide, I plan to revisit each blog post, add detail, implement changes based off of your feedback and thoughts, and then publish the guide into a book. While creating a book is a daunting task, the impact that I think this book will have on my community continues to motivate me.