When it comes to dealing with finances, one must accept that risk isn’t something that can be totally avoided. Most financial decisions carry a degree of uncertainty, which can lead to loss of capital. This is true not only for businesses, institutions, and governments, but also for individuals managing their day-to-day finances. These risks can come in many forms. A market downturn can affect your stock portfolio, an unexpected hospital bill can drain your savings, or a loss of employment can set you back a number of years. What’s in our hands, however, is to learn to manage these risks wisely. When conducted thoroughly, this process can give you clear view of your financial vulnerabilities and the means to handle them. So let’s have a look at some of the major Benefits of Risk Analysis and how you can get started.
Risk analysis is the process of understanding three key things:
- Identifying what could go wrong with your finances,
- Measuring how much loss you can handle, and
- The steps you can take to mitigate the effect of these unforeseen situations.
1. Helps You Identify The Different Financial Risks You’re Exposed To
As with anything in life, awareness is one of the first steps towards taking control. Once aware of potential risks to your money, take steps to reduce them to a manageable level. One of the most important Benefits of Risk Analysis is that it helps you recognise the various types of risks that could impact your money and financial goals. Take a quick look at the many shapes and forms these risks can take:
- Market risk: Factors like interest rate changes, geopolitical events, and recessions can cause market-wide losses.
- Liquidity Risk: One may not be able to fairly or quickly convert their assets into liquid cash. For example, if you need to sell a real estate investment urgently, you may have to wait longer than your circumstances allow or have to settle for a less-than-ideal price as the asset class is illiquid.
- Credit Risk: This type of risk is relevant to lending. The bond or loan issuer may not recoup the principal or interest as the borrower promised. This can lead to partial or total loss of the capital.
- Inflation Risk: If your investments don’t earn returns higher than the rate of inflation, your wealth decreases as the purchasing power of your money will erode.
- Policy Changes: The Government can change regulations related to capital gains tax, investments, and interest rates from time to time. This is the risk of making losses due to such reforms.
- Natural Disasters: Calamities like floods and earthquakes can unexpectedly cause physical damage and disrupt your income. Similarly, pandemics such as the COVID-19 outbreak showed us how sudden, large-scale events can impact jobs, businesses, and investments.
- Sudden Illness: A major health issue can lead to problems such as having to pay off high medical expenses, or taking on debt to deal with the situation.
- Loss of Employment: Job loss can make it quite difficult to manage necessary expenses, repay loans, or continue long-term investments.
- Life Risk: In case of your untimely death, your family may have to deal with financial hardship and be unable to achieve their long-term goals.
- Currency risk: arises when exchange rate fluctuations affect the value of your foreign investments or salary.
Every individual is exposed to different combinations of these risks. A financial advisor service can help you identify which of these are most relevant to your situation and which need immediate attention. For example, currency risk is more relevant to someone who invests in international markets, is an NRI earning in foreign currency, or someone who plans to send their children abroad to study.
2. Protects You from Debt and Major Financial Losses
We identified that unforeseen events like a sudden medical emergency, a market downturn, or a job loss can pose a risk to savings and investments. Such situations can force you to drain your savings, take loans at high interest rates, liquidate investments prematurely, and overall hinder your progress towards your long-term financial goals. That’s why financial planning services often advise their clients to protect themselves through a combination of risk management strategies, such as:
Creating Emergency Funds
An emergency fund is used to deal with smaller, unbudgeted expenses that can arise unexpectedly. For example, if your car breaks down and you are left with a hefty bill, you can rely on your emergency fund to take care of the expenses and leave your investments and savings untouched. This fund is usually kept separately in a liquid, low-risk instrument, such as a debt mutual fund or a high-interest savings account, so you earn decent returns while also keeping your money easily accessible.
Experts recommend having at least six months’ worth of living expenses in your emergency fund. These include your necessary costs like rent, groceries, bills, EMIs, and SIPs.
Getting Insured
When you insure your health or life, you essentially transfer the financial risk from yourself to the insurance company. Term and health insurance are non-negotiable for risk protection, shielding you and loved ones from significant financial hardship after serious illness or accident. These policies prevent your family from having to compromise on their standard of living or dip into long-term savings.
Diversifying Investments
Diversification helps you reduce investment-related risk. Instead of a single security, diversify investments across multiple asset types like equities, debt, gold, and real estate.
3. Aligns Investments with Your Risk Appetite and Goals
Keywords: online financial advisor
Your investment should always reflect your financial goals, investment horizon, and risk tolerance. Risk analysis assesses your risk appetite to select investments matching your current financial situation. If you work with an online financial advisor, they may use the following three factors to assess your ideal tolerance:
The Need To Take Risk
This factor focuses on how much risk you need to take in order to achieve your financial goals. To build a retirement corpus in 20 years, you may need to pursue higher-risk investments to reach your target.
The Ability To Take Risk
This factor measures your financial capacity to take on losses without having your lifestyle or long-term goals disrupted. It considers many sub-factors like your age, income, savings, existing investments, responsibilities, and debt obligations.
The Willingness To Take Risk
Someone might handle high risks, but lack the psychological tolerance for uncertainty and losses. That’s why a professional also ensures your investments suit not only your financial situation but also your mindset.
After receiving information, your advisor categorizes you as a conservative, moderate, or aggressive investor and recommends products.
4. Helps You Analyse the Risks Inherent in an Investment
As we’ve already discussed, every asset class and individual security comes with its own set of risks. The risk-return tradeoff states that as potential investment returns rise, the associated level of risk also increases. Basically, the higher the reward, the greater the uncertainty. That’s why safe investments like fixed deposits tend to return lower compared to risky assets like stocks and equity funds. So how can investors assess the inherent risk in a particular investment? Well, you can analyse factors such as:
- Past Performance: Taking an in-depth look at historical returns can paint a picture of how the investment reacts to different market conditions.
- Market Volatility: Also known as beta, this can help you assess how much the returns of an asset fluctuate over a period of time.
- Liquidity: You should understand how easily an asset can be sold at its fair price so that you can access funds when needed. For example, if you invest in an ETF with low trading volumes, you may find it hard to sell your units quickly without affecting the price.
- Creditworthiness: This factor is pertinent to debt instruments like bonds. Agencies such as CRISIL rate the issuer’s financial health, which helps investors understand the chances of timely interest and principal payments.
- Lock-in Periods: Some investments (like FDs and ELSS funds) come with mandatory lock-in periods, during which you cannot withdraw your funds, or may have to pay a fine upon withdrawal. Assessing this factor is crucial as it affects the investment’s liquidity.
- Risk-adjusted Returns: These metrics look at returns delivered by an investment under a different light. They measure how profitable an investment is relative to the risk it takes. Different metrics like the Sharpe Ratio, Treynor Ratio, and Sortino Ratio allow you to compare investments more accurately as they account for volatility or downside risk.
5. Improves Decision-Making and Preparedness
Warren Buffett once famously said, “Risk comes from not knowing what you’re doing.” Knowledge and awareness can equip you to manage uncertainty confidently and without letting emotions dictate your choices.
One of the most valuable Benefits of Risk Analysis is that it improves your ability to make financial decisions. Many investors in our country tend to avoid high or medium risk investments even when they have the ability to withstand losses. This hesitation often stems from a lack of understanding about the types of risks involved and the strategies available to mitigate them.
Conclusion
These five Benefits of Risk Analysis highlight just how important it is to approach financial planning with awareness and strategy, because risk is the unavoidable truth of financial life. Since it cannot be completely eliminated, we must take the necessary steps to identify, estimate, and mitigate risk to protect our wealth and ensure we remain on track to fulfil our financial dreams.
