The 3 Biggest Risks to Your Money
And how you can manage them and spend less time worrying about your finances
To be great at managing money, you need to be great at managing risk. The first step to managing risk is identifying which risks you need to be concerned with.
The three biggest risks to your money over the course of your life are;
- Earnings risk.
- Mortality risk.
- Longevity risk.
In this article, I will review each of these risks in detail and what steps you can take to manage these risks and spend less time worrying about your finances.
1. Earnings risk
Earnings risk refers to the risk that you lose your job, your business fails, or you have some other type of negative shock to your earning potential.
The most important asset you will ever own is your “human capital,” which is an economist's way of saying “your ability to earn income.” To be great at managing money, you need to have some money to manage, which means your primary financial focus should be to earn as much income as possible.
If your human capital is the largest asset you’ll ever own, then the greatest financial risk you’ll face is losing your ability to earn income.
To manage earnings risk, focus on increasing your savings rate
Increasing your financial capital (cash & investments) is the perfect hedge against your human capital.
- If you lose your job and have no savings, you’ll be in for a world of financial hurt.
- On the other hand, if you lose your job and have enough cash and investments saved up that you could get by for 6 months or longer without any income, you’ll give yourself a large runway to get back on your feet.
Unless you’ve been given a large inheritance or won the lottery there is only way to obtain financial capital; save a high percentage of your income.
Increasing your savings rate allows you to build up more financial capital and reduce the risk of a job loss or negative shock to your income.
There are two ways to increase your savings rate
Your savings rate refers to the proportion of your take-home pay you save. If you cleared $1,000 per paycheck and saved $100, you would have a 10% savings rate.
There are two ways you can increase your savings rate.
- Spend less money while keeping your income constant.
- Make more money while keeping your spending constant.
Pulling the savings lever
Here is an important truth you need to remember.
Decreasing your monthly expenses by $500 has the exact same impact on your savings rate as increasing your income by $500.
In fact, reducing your living expenses has a more significant impact than increasing your income for two reasons.
- It’s more tax-efficient. At a 30% marginal tax rate, cutting $500 in monthly expenses is equivalent to increasing your monthly income by $715 in monthly passive income.
- You can achieve this increase in cash-flow instantly. Increasing your income means earning more per hour or working more hours. Either option takes time, whereas you can spend a few hours redoing your budget to instantly cut your monthly expenses.
If your serious about spending less money, I would recommend you start by taking a hard look at your big 3 expenses.
3 Costs You Need to Control to save More Money
The importance of managing the big 3 living expenses
Making more money
There are endless ways to make more money, but the method I am laser-focused on these days is creating a side hustle with scalable income.
Scalable income means there is no limit to your earning potential, but you aren’t guaranteed to make a cent.
Starting a side business to supplement my paycheck from my 9–5 job has allowed me to double my income in less than three years. Since I have been able to keep my expenses constant, I have been able to increase my savings rate to 83%.
For every $1,000 I make, I am saving $830. This has allowed me to quickly build up enough financial capital where I could easily maintain my current lifestyle for over a year if my income were to go to $0.
The real beauty of having a side business and a 9–5 paycheck is that the probability of my income falling to $0 is exceedingly low.
I am rapidly approaching the point where the net income from my side business is equal to the take-home pay I earn from my 9–5 job. This diversification of my income means if I were to lose my job, my business income could easily cover all of my living expenses.
This adds a second layer of managing my earnings risk and reduces the possibility that I will ever need to rely on my financial capital during my working years. This means my financial capital can continue to compound and grow to support me during my retirement years.
2. Mortality risk
You might think that with a 9–5 job and a growing side business, I have done everything I need to manage my financial risks.
But what happens if I were to die tomorrow?
My paycheck from my 9–5 job and the income from my side business would go to $0.
If I died tomorrow there would be enough financial capital to keep the ship afloat for a while, but without my human capital, where would my wife and infant son be in 10 or 20 years from now?
That question is the perfect incapsulation of mortality risk, the risk of dying prematurely, and your family losing your income earning potential.
The simple and cheap way to manage mortality risk
Mortality risk is relatively simple to quantify; it’s the present value of all the future income you expect to earn in your life.
- The younger you are, the higher your future earnings potential is because you have more working years left.
- While at the same time, your financial capital is relatively low when your young because you’ve had fewer years to save money.
I am 32 with a 10-month old son, which means the biggest risk to my family’s financial future, is the risk that I die prematurely.
Luckily, mortality risk is the easiest and cheapest of the three risks to manage. All you need to do is purchase cheap term life insurance.
Term life insurance is exactly what it sounds like. You select the number of years you want coverage for, how much insurance you want to buy, and start paying premiums.
Let’s say you qualify for and buy a 20-year life insurance policy with a $500,000 death benefit. If you die within that 20-year window, your beneficiaries receive $500,000.
At the end of the 20 years, you need to renew the policy if you wish to maintain coverage. The premium will increase because the longer you live, the more likely you are to die.
However, this is not necessarily ya problem because the older you get, the lower your insurance needs are;
- You have fewer working years remaining, so you have less human capital you need to replace.
- You (hopefully) have built up significant levels of financial capital that could sustain your family in the event of your passing.
This means that you can renew into a lower coverage amount if you’re worried about increasing premiums. The exception would be if you have not been saving during your working years as there is an inverse relationship between your level of financial capital and your life insurance needs.
3. Longevity risk
When most people reach retirement age, they begin drawing down on their financial capital to cover their living expenses. Once you reach this point, the biggest risk to your money is longevity risk; the risk that you outlive your money.
When you reach retirement, one of the scariest financial questions is, “how long will my money last?”
Once you start drawing down on your principal, the clock starts ticking to when you run out of money.
A lot of retirement plans aim to draw down your retirement nest egg based on your life expectancy.
For example, if you retire at age 65, a financial planner could build a plan for you to draw down your savings until age 95 (or to whatever age you want your money to last.)
Longevity risk would be building a financial plan where your money would run out at age 95, but you end up living until 105. That leaves you with 10 years of no human or financial capital to sustain your lifestyle.
Managing longevity risk
Longevity risk was not a big deal when most people had access to a Defined Benefit pension through work.
Sadly, few private-sector workers have access to a pension these days and need to rely on their personal savings to fund their retirement. This task has become exceedingly difficult as life expectancy has increased, and with it the number of years in retirement.
While you may not have access to a pension, you have the option of buying one when you reach retirement. I am referring to the option of buying a lifetime annuity.
A lifetime annuity is a financial product you can buy through an insurance company that will provide you a guaranteed monthly income for the rest of your life. In that way, it acts exactly like a pension.
Basically, you would hand over all or a significant portion of your retirement savings in exchange for a guaranteed monthly income.
That way, you can continue funding your lifestyle without fear of running out of money no matter how long you live.
Annuities are very complex financial products and often have very large fees associated with them. If an annuity is an option you are considering, I highly recommend sitting down with a fiduciary financial planner and having them work through the details.
The other option and the route I am taking is to simply build up so much financial capital that it can fund your lifestyle forever.
If you had $10 million saved and could happily live off $50,000 per year, the odds that you would ever run out of money are next to nothing.
That is an extreme example, but the idea is that if the income you generate from your portfolio is sustainable and enough to cover your living expenses, you would never need to touch the principal, and there would be no worry about outliving your money.
This is not an option available to most people as it requires a significant amount of savings each year of your working life. But, if you are in the privileged position to able to amass that level of financial wealth, you don’t need to worry about longevity risk.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.