Risk is an unavoidable part of life and, by extension, an unavoidable part of financial planning. While the word ‘risk’ often carries negative connotations, the reality is more nuanced. While some risks are destructive and should be avoided altogether, others are necessary if we are to grow our wealth over time. Some risks cannot be avoided, but can be mitigated through careful structuring, appropriate insurance and disciplined planning. And then there are risks that, after careful consideration, we may consciously choose to live with.
Good financial planning is not about eliminating risk entirely, but rather about identifying the risks that exist, understanding their potential impact, and then deciding whether to avoid, reduce, transfer or accept them. Avoiding risk means steering clear of risks that have no place in a well-constructed financial plan, such as speculation or investments that are not properly understood. Reducing risk may involve diversification, liquidity planning, estate planning or debt reduction. Accepting risk means consciously choosing to live with a risk because it is either affordable, manageable or not worth insuring against.
In financial planning, transferring risk means shifting the financial consequences of a particular event from yourself to another party, most commonly an insurer. For example, while life cover cannot prevent death, it can transfer the financial impact of that death by providing capital to one’s dependants or estate. Similarly, income protection cannot prevent illness or injury, but it can transfer part of the income-loss risk by replacing a portion of one’s earnings while one is unable to work. Importantly, risk transfer does not remove the event itself; rather, it reduces the extent to which the individual, family or estate must carry the financial burden when that event occurs.
One of the most important distinctions to make is the difference between avoidable risk and necessary risk – and nowhere is this more evident than in the investment space. As investors, there are certain risks that can, and in our view should, be avoided altogether. Speculation, market timing, concentrated bets, unregulated schemes, offshore trading platforms promising unrealistic returns, and investments that are not properly understood do not generally form part of a prudent financial plan. While there will always be stories of investors who made quick money through speculation, there are far more stories of those who suffered permanent capital loss by investing in something they did not understand, could not value or could not exit from.
That said, avoiding unnecessary investment risk is not the same as avoiding all investment risk. One of the greatest risks faced by long-term investors is being too conservative with long-term money. While cash and fixed-income investments have an important role to play, particularly for emergency funds, short-term goals and income needs, they are unlikely to deliver sufficient real returns over time. Being invested too conservatively for a long-term horizon is likely to result in inflation quietly eroding the purchasing power of money, meaning that a portfolio that feels safe in the short term can become increasingly risky over the longer term.
To achieve long-term growth, investors need exposure to growth assets such as equities and, depending on their circumstances, listed property and offshore assets. By their nature, these asset classes are volatile and move through cycles of growth, correction and recovery, with short-term volatility being the price investors pay for long-term capital growth. Volatility risk can be managed through appropriate asset allocation, diversification, rebalancing, time in the market, and an investment strategy aligned with the investor’s objectives. The key is to distinguish between volatility and permanent capital loss, keeping in mind that while a well-diversified portfolio may fall in value during periods of market stress, this does not necessarily mean that the investor has suffered a loss – unless they are forced to sell at the wrong time. On the other hand, investing in a speculative scheme, unregulated product, or a single high-risk asset is different, as it can result in permanent capital destruction.
Risk also needs to be considered in the context of behaviour. Selling after a market correction, chasing last year’s top-performing fund, switching strategies too frequently, or allowing fear and greed to drive decision-making can do more damage than the market itself. While behavioural risk cannot be insured against, it can be mitigated through proper planning, ongoing advice, and the discipline to remain invested through difficult periods.
Longevity risk is another important consideration, particularly when planning for retirement. While living longer is something to be celebrated, it also increases the risk of outliving one’s capital, particularly where drawdown rates are too high, investment returns are too low, or the portfolio is positioned too conservatively for the retiree’s income needs. Retirees who avoid investment risk altogether may inadvertently increase the risk that their capital fails to keep pace with inflation over a retirement that could last 25 or 30 years. Managing longevity risk requires careful income planning, realistic drawdown assumptions, appropriate exposure to growth assets, regular reviews and the discipline to adjust spending where necessary.
Personal risk cover deals with a different category of risk altogether. These are risks that we often cannot avoid, but which can have devastating financial consequences if they are not properly planned for. Death, disability, illness and medical events cannot be eliminated through planning, but their financial impact can often be transferred through appropriate cover. In this sense, insurance is not an expense in isolation; it is a mechanism for protecting cash flow, preserving capital, creating liquidity and preventing a single event from derailing the broader financial plan.
Death is the most obvious example. Life cover is not primarily about the person who dies, but rather about those who are left behind. Its purpose is to provide capital to settle debt, maintain the family’s standard of living, fund education costs, provide estate liquidity and give surviving family members financial breathing room at a time of emotional trauma. The correct level of cover depends on the individual’s debt, dependants, assets and existing liquidity.
Life cover can also play an important role in addressing liquidity risk in one’s estate. A person may be asset-rich but cash-poor, with wealth tied up in property, business interests, retirement funds or other illiquid assets. On death, the estate may need immediate liquidity to settle executor’s fees, estate duty, capital gains tax, outstanding debt, maintenance obligations and other administration costs. Without sufficient liquidity, heirs may be forced to sell assets at an unfavourable time or place pressure on surviving family members to fund shortfalls. Properly structured life cover can provide the liquidity needed to wind up the estate efficiently and ensure that assets intended for beneficiaries do not have to be sold unnecessarily.
Disability cover is another important risk protection mechanism, although in this context it’s important to keep in mind that there is often a greater likelihood of being unable to work temporarily as a result of illness, injury, surgery, mental health challenges or recovery from a medical event than there is of becoming permanently disabled. For most working professionals, their future income is their single biggest asset, and protecting it should therefore be a central part of any financial plan. A temporary inability to earn an income can place immediate pressure on household cash flow and, as such, should be protected against through appropriate income protection.
Private healthcare funding is another area where risk cannot be ignored, keeping in mind the sometimes prohibitive costs of accessing healthcare in private facilities. While private medical aid provides access to private healthcare and helps fund hospital and day-to-day medical expenses, depending on the plan selected, even comprehensive medical aid does not necessarily cover all costs in full. Although gap cover does not replace medical aid, it can help reduce the risk of large out-of-pocket expenses following hospitalisation or certain approved procedures and is an important component in a portfolio designed to protect against the risk of ill-health.
That said, not every risk needs to be insured, and not every risk can be transferred. A person with sizeable liquidity may choose to self-insure against smaller risks, someone with no dependants may choose not to hold life cover, and a retiree with no earned income may no longer need income protection. The point is not to insure against every possible event, but to make deliberate decisions based on affordability, probability and potential impact.
This is why risk planning should never be done in isolation, and why insurance should be integrated into the broader financial plan, taking into account cashflow, debt, estate liquidity, tax, investment assets, retirement funding, dependants, employment benefits and existing cover. Over-insurance can place unnecessary pressure on monthly cash flow, while under-insurance can leave a family financially exposed. The key is to find the balance between risk that needs to be insured against and risk that can be self-funded, without losing sight of the fact that circumstances change over time and risk should be reviewed regularly.
Ultimately, financial planning is about making risk conscious rather than accidental. It is about avoiding risks that have no place in a well-structured plan, taking necessary risks in a controlled and deliberate manner, transferring risks where the potential financial impact is too great to absorb, mitigating risks that could derail financial security, and accepting those risks that are manageable within the context of one’s overall position. A resilient financial plan is not one that attempts to remove risk altogether, but one that ensures each risk is understood, appropriately managed, properly priced and regularly reviewed as life unfolds.
Have a super day.
Sue
