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Individuals seeking financial advice today have more options than ever before. While friends, family, and colleagues have always been a trusted resource, we are now awash in a sea of financial information, including from websites, social media, and robo-advisors.
Some of these sources of financial planning may be more reliable than others. It’s important to understand that a certified wealth planner can make an impact when it comes to managing financial risk and uncertainty. But before we explore why, we need to cover the fundamentals of risk and uncertainty.
Understanding Financial Risk Management
Financial risk management is a personal process that helps individual investors preserve and grow their wealth while preparing for the unexpected. Here are the core components:
- Preparation over control. Risk management isn’t about eliminating the risks of life altogether. Instead, it’s about being prepared for the potential impacts on you, your family, and your portfolio if the unexpected happens.
- Knowing your risk tolerance. Risk management is personal. Your financial situation is different than anyone else’s. Your goals, income, assets, liabilities, and overall risk tolerance are all crucial factors that must play into your comprehensive plan.
- Transferring risk. A core component of risk management is insurance. Whether it’s for your assets, like real estate, or for your health, like long-term care, insurance is a key tool that can help you trade volatility for certainty.
Financial risk management helps wealth managers deal with the unknown on behalf of their clients. It’s a holistic process that must account for all different facets of an individual’s financial life.
But financial risk management is not done in isolation. When wealth managers approach a client’s portfolio, they must zoom out, focusing on the macroeconomic factors at play, then distill their insights down into actionable strategies.
Key Concepts in Economic Uncertainty
Ultimately, financial risk management is about tailoring your portfolio to withstand the uncertainties of the global macroeconomic environment. But which factors do advisors account for when they make decisions? Here are some of the key concepts:
- Market volatility. Sudden changes in market prices can significantly impact portfolio value. Wealth planners can manage this risk by using effective diversification strategies.
- Inflation. Rising prices erode purchasing power over time. Some asset classes, like real estate or commodities, can serve as an inflation hedge.
- Interest rates. In one way or another, interest rates have an impact on almost all investable assets. By adjusting portfolio allocations between assets that perform differently in different interest rate environments, you may be able to reduce the impacts.
- Geopolitical events. Elections, wars, or changes in policy can affect portfolio performance. While these can be hard to predict, a well-designed portfolio can reduce their impact when they occur.
By monitoring all these factors—and more—your advisor can help you manage uncertainty. But while it’s important for your advisor to do so, it can help to have an understanding of these topics for yourself as well.
To assist you in gaining a clearer understanding of financial risk management and uncertainty, we’ve created the following guide. By following these steps, you’ll gain more knowledge of the macroeconomic landscape; you’ll also learn more about your unique financial mindset and goals.
Financial Planning Guide for Handling Uncertainty
These questions and thought exercises will help you understand what goes into creating a financial risk management plan through a series of categories.
First, evaluate your financial goals, as these will shape the way you manage risk.
- Retirement. How close are you to retirement? How much do you still need to save?
- Lifestyle. Do your current spending (and saving) habits support your goals?
- Legacy. What do you want to leave behind, and to whom?
With your financial goals in mind, quantify your risk tolerance.
- Define roughly how much risk you’re comfortable with.
- Factor in your age, time horizon, and current and projected income.
- Assess your current financial plan. Does it allow you to achieve your goals within your current risk tolerance?
An important part of financial risk management is monitoring the overall economic landscape over time. Develop a process that helps you keep track of:
- Market movements
- Inflation
- Interest rates
- Monetary Policy
- Geopolitical events
- Other trends that could inform specific investment decisions
Review your insurance policies, and see where you could be missing coverage—or where you have too much:
- Home insurance
- Umbrella coverage
- Health insurance
- Auto insurance
- Long-term care insurance
- Disability insurance
- Professional liability insurance
Choose the right financial advisor.
- Know what you want from your advisor.
- Understand the differences between advisor standards.
- Choose an advisor who can meet your expectations.
- Personality fit?
Choosing the Right Wealth Advisor
That last category might sound a little opaque to someone unfamiliar with the financial advising world. We’re here to explain.
Choosing a financial advisor that’s right for you can seem complex, but there’s one choice that can be very simple: the choice between an advisor that’s held to a fiduciary standard, or one who is not. A fiduciary advisor is legally required to act in your best interest, whereas advisors who are not held to a similar standard may prioritize their own interests.
With that in mind, let’s look at two common standards for advisors: the Broker-Dealer Best Interest Standard, and the Certified Financial Planner (CFP®) Standard.
Broker-Dealer “Best Interest” Standard
Established by the Securities and Exchange Commission’s (SEC) Regulation Best Interest (Reg BI) in 2019, this standard applies to broker-dealers. Under it, broker-dealers must:
- Act in the best interest of their retail customers when making investment recommendations.
- Disclose conflicts of interest and take steps to mitigate them.
- Exercise reasonable care, diligence, and skill when making recommendations.
Notably, the Reg BI standard does not require advisors to continuously monitor accounts or provide ongoing advice.
Certified Financial Planner (CFP®) “Fiduciary” Standard
CFPs are held to a fiduciary standard, which is generally considered a higher standard of care than the Reg BI. Under this standard, CFPs must:
- Act in the best interest of their clients at all times when providing financial advice.
- Adhere to a duty of loyalty.
- Place their client’s interests above their own.
- Provide comprehensive and ongoing financial planning advice.
- Avoid or fully disclose and manage all conflicts of interest.
Understanding the Differences Between Reg Bi and CFP Standards
There are a few key differences between these two standards; differences which may play into your decision as to what type of advisor to partner with.
- Scope. The CFP standard applies to all aspects of the financial planning relationship. The Reg BI standard applies primarily to specific investment recommendations.
- Continuity. CFPs have an ongoing duty to their clients. Broker-dealers’ obligations are typically transaction-specific.
- Breadth. CFPs typically provide comprehensive financial planning services, while broker-dealers may focus more on investment products and transactions.
Both of these standards obligate financial professionals to act in their clients’ best interests. However, you need to understand which standard applies to the financial advisor you’re considering, and how that might affect the advice and services that you receive.
The Role of Financial Advising in Preparing for Uncertainty
No matter which standard your advisor is held to, the principles of financial risk management stay the same. It’s about understanding where you are today, where you’d like to be tomorrow, and how you can put the right instruments and tools in place to preserve you as you get there.
While there are numerous different sources of advice out there, working with a certified wealth planner who understands both your personal risk tolerance and your unique goals and objectives can help you tailor a comprehensive plant that serves you.
Choosing an advisor to help you manage financial risk and uncertainty is a significant step towards a more confident financial future.
Related: Simplifying Inheritance: Effective Strategies for Passing on Assets