We face risks in every area of our lives, and the realm of personal finance is no exception. Successfully managing financial risk is key to achieving a comfortable and secure lifestyle. At its core, managing financial risks starts with identifying them, determining what could go wrong and how bad it could get. Only then can we construct a risk management plan to protect against potentially catastrophic events. Sensible people learn to take calculated risks that propel them toward their most important life goals and protect against those whose consequences are too great to bear.
Most commentary on financial risk focuses on the ones individuals face in the capital markets, primarily losing money on their investments. However, the decades-long process of working, spending, and saving is fraught with an array of non-investment risks that pose greater threats to a household’s financial security. Still, few personal plans take them into account.
The theory, known as “lifecycle finance,” explains how individuals and families can maximize their standard of living by making smart financial decisions during the various phases of their lives. It also offers an excellent framework for developing a sensible risk management program. A central concept of lifecycle finance is the distinction between two types of wealth, human capital, and financial capital. In simple terms, human capital is our future earning potential. Financial capital, on the other hand, represents the amount of net assets, after paying off debts, we have already accumulated and are available to support us in the future.
At the start of our careers, we have lots of human capital and little financial capital. In theory, and hopefully in practice, as our human capital (remaining years in the workforce) steadily declines, it is converted into wages. Those wages are used for current living expenses, paying down debt and saving. The savings becomes the financial capital, and when properly invested, grows to generate the assets and investment income needed to fund future goals, and ultimately, a comfortable retirement.
A well-conceived risk management plan should protect against perils to a household’s human capital (cash flows) and financial capital (net worth).
I’ll start with a discussion about protecting our human capital.
For the decades of work when human capital represents the dominant portion of our wealth, the key variable to achieving financial security is cash flow. Cash flow is the inflow and outflow from our earnings and spending. The difference between a household’s after-tax inflows and outflows is the net cash available for saving and investment. A consistent source of investable funds is by far the most critical factor in building the financial capital needed to support future goals.
A family’s ability to sustain a positive cash flow is vulnerable to threats ranging from overspending to an unexpected drop in income from a job loss, disability or death. The first scenario requires the simple but demanding commitment to reduce and limit spending so that large percentages of future income growth (raises, promotions, etc.) go toward saving, investing and paying down debt. The second requires a multi-pronged approach including improving job skills to ensure career advancement, maintaining a healthy lifestyle, and constructing a smart disability and life insurance program to protect against a loss of income. Neither disability nor life insurance is cheap, so over insuring by failing to do the requisite analysis could prove costly. Start by quantifying the impact on the family finances for the risk you are insuring against. For example, determine how other family members can mitigate the consequences by reducing expenses or increasing income. The balance is what you need to insure for. As a household’s financial capital grows the need for disability and life insurance should steadily decrease as accumulated financial capital will provide “self-insurance” against risks to an individual’s cash flow. Conversely, as family income increases and household expenses and debts grow, increasing insurance coverage will likely be warranted.
In our next post, I’ll talk about protecting our financial capital.