Anthony Stone / Kevin P. Kilburn / et al
This is the first of the "Risky Business" series on our blog. This first post is an introduction to Risk Management and how it can (should) be used in personal finance. Future posts will elaborate on the specific risks associated with some popular "get out of debt in 7 easy steps" programs popularized by some financial celebrities.
Before you embark on any journey, whether it's a car ride in the rain, a boating excursion, hunting trip, or debt elimination, you must assess your risk lest you encounter a situation that causes you problems because you were unprepared. Everyone performs Risk Management to some degree. We do it subconsciously, so we're not presenting a revolutionary concept, only how to make it more deliberate. Something as simple as driving slower and using headlights and wipers in the rain is risk management. We'll show you how to identify risks in personal finance and mitigate them rather than blindly following the advice of financial celebrities whose cookie-cutter approaches are ill-suited for many situations.
The Stone Money Foundations adopts a military definition for risk:
Risk is the probability and severity of loss linked to a hazard.
Don't let the fact that we're using the U.S. Army definition for risk scare you off. I used the Army's risk management process for 28 years during my service. It's a proven process and it will help you in your personal finance journey. We'll use a very simplified version because you have more important business to get to other than learning volumes about Risk Management.
After you read this post, you'll understand the basics of Risk Management that you can use in your personal finance. Following a financial celebrity's plan without assessing your own personal risk can cause more problems than the program solves.
Process
Our Risk Management process consists of 4 steps:
Identify hazards--the events/situations that will cause you problems.
Identify the risk--the probability and severity of loss linked to those hazards.
Develop mitigation measures to lower the risk.
Implement the mitigation measures.
Let's first take a look at the definition of risk in detail.
Identify Hazards
Hazards in personal finance aren't things that will cause physical injury, but they can nonetheless devastate your well-being. Examples of hazards in personal finance include: emergencies (and not being able to cover those emergencies with cash on-hand); overextending credit; not being able to pay for food, housing, or transportation; job loss or other event that causes loss of income; medical issues; and other things that impact your ability to eliminate debt and remain debt-free. You must also consider hazards that prevent you from maintaining a sufficient emergency fund and investing for retirement/college. Too many unmitigated hazards now will chip away at your savings and impact your future.
Risk: Probability of Loss
You have to consider the probability of loss based on particular hazards. For example, one common hazard we all face is the failure of certain parts in your car, like the water pump. Water pumps fail at around 60,000 to 90,000 miles. Based on this statistic, the probability of your water pump failing is far less at 20,000 miles than at 93,000 miles. You don't need to figure percentages or anything like that. A simple assessment of high, medium, or low is fine. This is somewhat subjective based on your research, knowledge, and experience. This gives you an idea of what hazards are most likely to occur.
Ideally, you'll have an emergency fund (money for unforeseen events) and sinking funds (savings account for known events) to mitigate these hazards, but when you first begin your debt-free journey, you may not have these accounts funded yet. This creates a level of risk that you must mitigate.
Risk: Severity of Loss
You must also assess the severity of loss based on particular hazards. Continuing the water pump example, if it fails (usually while driving), then the result is catastrophic. At a minimum, you'll be stranded on the roadside. At worst, your engine will be damaged. Winter will compound this situation. In any case, the severity of loss (or inconvenience) is going to rank very high. Assessing the severity gives you an idea of what hazards are most dangerous if they occur.
Probability = most likely to happen; severity = most dangerous to happen.
Probability and severity combined, they give you the overall risk--very high, high, medium, low, very low.
Develop Mitigation Measures
Once you identify your overall risk--the probability and severity of loss linked to a hazard--you must develop mitigation measures to eliminate or reduce that risk. Eliminating risks is difficult, so your goal is to at least reduce them to an acceptable level if you cant get rid of them completely.
Going back to the water pump example, you could mitigate the risk associated with the failure of the water pump (hazard) by replacing the water pump early (e.g., 50,000 miles). If that isn't feasible, then you might mitigate the impact of a failure by not transporting children in the vehicle, keeping inclement weather items in the car (blanket, umbrella, road flares, walking shoes, etc.), having an external cell phone battery, going only on main roads where help can be summoned, etc. You will still need money to replace it after it fails, so a mitigation measure is to save or have credit available.
As you develop mitigation measures, you reassess your risks. The water pump may be a very high risk, but once you implement mitigation measures, it could be medium to low. You may determine that the impact (loss) of breaking down on the side of the road really isn't all that problematic for you. This is the whole point of Risk Management--to implement measures that reduce risk to an acceptable level. This is your judgment call, not that of some financial celebrity. What may be a high risk for someone else could be a medium risk for you.
Implement Mitigation Measures
This is the most important step. No amount of planning and discussing mitigation measures is effective until you actually implement them. Procrastination is your biggest enemy. If the water pump is good at 50,000 miles, then surely it's okay at 55,000. And if it's good at 55,000... Before too long, you're at 95,000 miles and stranded on a highway because your water pump failed.
Conclusion
Future posts in the "Risky Business" series will focus on specific personal finance examples. Of particular danger is the notion that a $1,000 starter emergency fund is sufficient to carry you through 2 to 3 years of debt repayment before you establish a 3 to 6 month "fully funded emergency fund".
Having only a 3 to 6 month emergency fund is also dangerous and grossly outdated. Some financial celebrities, like Suze Orman, have changed their recommendation over the years to increase the amount to 12 months based on situations like the COVID-19 pandemic. On the other hand, Dave Ramsey has held steadfast with his decree of 3 to 6 months because it has worked for billions of people for centuries.
Anyone who has gone years with only a $1,000 emergency fund has survived through luck, not design. It's like looking back on a game of Russian Roulette and attributing your survival to your expert skill. This should be obvious, but the willfully ignorant insist they are succeeding through design (Ramsey's program).
If you follow the advice of any radio/TV personality just because they yell the loudest over all the others or because they have such a charming personality, then you are putting yourself at very high risk. Even if their advice has "helped millions", it may not be for you.
If you visit any financial celebrity's official website, you're usually greeted with an advertisement for something they're selling (and if not, then it's just a few clicks away). Just understand their motivation as you listen to their advice. Are they pushing exclusively a $1,000 starter emergency fund and Debt Snowball because they represent the best course of action or is it because those principles are so deeply ingrained in their brand that they refuse to promote alternate, but viable, solutions?
A strong foundation is made of Stone.