Common Misconceptions of Risk Management

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In a prior blog post, we discussed common myths about post-retirement employment. As covered, many Americans believe they’ll be able to cover any shortfall in retirement funds by continuing to work. But this expectation may be disrupted by health issues or other unanticipated life changes.

Like expectations about working longer, there are some common misnomers about risk management in retirement, as well. “Risk management” refers to the amount of risk someone tolerates in their financial portfolio – or the potential for their investments to experience a setback. It shows the flip-side of retirement planning: Having a plan in place is optimal, but it’s important to be prepared for making readjustments, as well.

Let’s consider some prevailing myths about risk management in retirement planning – and how you can avoid these downsides in your own efforts.

What are Some Common Misunderstandings about Risk?

During the 2008-2009 financial crisis, investors got a hard lesson in risk management. Between December 2007 and December 2008, the S&P 500 experienced a 37% decline. In turn, this brought about $2.8 trillion in retirement account losses.

Since then, many American households have recovered, if not exceeded their losses. But misconceptions of risk management continue to linger. Here are a couple of prevailing trends:

Forecasting for the future has a set formula for everyone – Managing your risk means you’ll have to determine what’s going to be happening in future years. But opinions differ in financial circles as to what exactly forecasting is. One popular notion is that forecasting is deciding asset allocation – or your investment holdings – based upon life conditions, needs, and the market risk tolerable at your age.

Another view is forecasting involves far more outcomes to consider. In short, this approach boils down to considering a variety of outcomes based on probabilities. But the truth is it doesn’t matter how one defines financial forecasting. Everyone’s needs are different, and everyone will be wrong about a prediction at some point. A solid, proactive approach is to plan for the worst and be ready to make adjustments to your retirement plan as necessary.

Risk tolerance will remain static – Financial planning is based on individual perceptions. It’s a measure of what someone expects for the future and allocating resources to have a secure retirement. Another common trend is expecting your appetite for risk to stay the same throughout your life.

However, as time passes outlooks change – and perceptions along with them. Changes in life circumstances – a medical emergency, shortfall in investment holdings, children having children of their own, to name a few – bring about evolution in perspective. Life events require adaptation for you to keep a healthy life balance. So the same principle applies to finances. As you age or other life events occur, your financial perspective and risk tolerance are also likely to change. It’s important to be open to this changing reality in your financial planning.

Risk models “guarantee” protection against shortfalls – Some investors may adopt processes of quantitative risk management in their financial plan. This approach involves taking historical data and using it to create risk models for predicting future market activity. Sure, this modeling is useful for providing further context and insights. But quantifying risk potential also comes with its own downsides.

For one, risk models depend upon historical data. These are insights of what happened in the past – they’re not necessarily representative of what might happen in the future. For context, consider the recent stock market correction. Aside from investor concerns about whether the Federal Reserve would raise interest rates, the global financial turmoil in late August stemmed from a slowdown in the Chinese economy.

Chinese manufacturing had hit a 77-month low – an unexpected development given how China’s economy had been growing like clockwork in years past. In turn, the manufacturing slump prompted a strong decline in the Shanghai Composite Index. This led to high-volume selloffs in markets across the globe. An unprecedented event – and one which shows how a risk model could show where areas of risk exist, but not how they will manifest and occur.

Need Help with Your Finances?

No matter what approach you take to your finances, education is paramount. Via, you have access to a full range of articles on hotbutton financial topics. There are resources covering annuities, life insurance, Social Security benefits, IRAs, estate planning, retirement income planning, and more. Please feel free to use this content so you can make retirement decisions with confidence.

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Author: Super User

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