A Simple Framework for Managing Personal Finance Risks

by Vinaya HS on April 6, 2012

in Finance

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Here’s something that I happened to read the other day –

I am an old man and have known a great many troubles, but most of them never happened. Mark Twain.

Leads to some interesting thoughts — How many months [worth of monthly expenses] is too many months in your emergency fund? Should you really be prepared for every possible emergency that life can throw at you? Should you (or your financial investments) really be prepared for every possible financial risk?

In my line of work, we look at a risk in terms of its likelihood (probability of occurrence) and impact (magnitude of loss on occurrence). Perhaps this could be a good framework for planning ones personal finances as well. Look at the illustration below.

Risk Likelihood Impact

For example, the likelihood of a job loss is high and its impact when you don’t have a financial buffer (emergency funds, alternate sources of income, etc.) is high. Then you really do need to worry about this scenario and work towards mitigating it. But the chart shouldn’t just be seen as snapshot at a point in time. So as you work hard towards building that financial buffer the impact starts decreasing and at a point there’s no need to worry about it any more (having a fatter emergency fund after this point doesn’t really change anything).

A good strategy would be to evaluate your risks periodically (once every quarter) against this framework — your goal should be to move everything to an “Ignore.”

What do you think?




Thanks for reading this article. I'd love to hear your opinion. Please use the comments section below to share your thoughts. I frequently write new articles that also cover several other aspects of personal finance including credit cards, financial goals, health insurance, income tax, life insurance, mutual funds, retirement planning, and much more. You can Subscribe through Email and receive new articles directly in your Inbox or you can Subscribe through the RSS Feed and receive new articles in your feed reader.

{ 2 comments… read them below or add one }

Rakesh April 6, 2012 at 9:49 PM

@Vinaya,

I too have a fatter emergency fund which at times i feel is not required but then its in FD and returns are safe and guaranteed. Do not want to take any risks by investing in other avenues.

Vinaya H S April 7, 2012 at 11:19 AM

@Rakesh –

Given the current state of the capital markets, I’d agree. :-) 9% – 10% assured returns is something I too would be very very comfortable with.

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