Dealing with Risk
Risk is an integral part of all our lives. Every decision we make and every opportunity we wish to seize holds risk. How and where do we want to live? Which training and which job would we like to do? And what kind of partnership would we like to have? There is no guarantee that things will turn out the way we want them to.
This also applies to financial decisions. We can certainly avoid some risks. But if we want to reach goals in life, we also need to learn to deal with risks. When we change jobs, start a new education or take out a loan to buy a house, we seek to make positive changes in our lives. At the same time, we accept the risk that things might not go as planned. This is why it is important to know what is meant by risk, to be able to identify potential risk factors and to learn how to manage risk.
Definition of risk
Risk refers to the possibility of a certain event or action occurring which will produce results that are difficult to predict and adversely deviate from what was desired or intended. In all of this, chance can play a role too. In everyday language, we often associate the term risk with dangers or uncertainties. However, risk can also be considered as an opportunity with positive results. The impact of risk events may be felt both financially, resulting in investment gains or losses, and nonfinancially, provoking emotional reactions to losses or strokes of fate. Of course, it is not just private individuals who are faced with a variety of risks, it is all economic agents. In this section, however, the focus will be put on private individuals and the financial risks they might face.
Risk factors
The risk factors we encounter in different areas of life can overlap. Often times, changes in one area of life will lead to changes and risks in another area.
In our personal life, good health plays a particularly important role. Potential risks to our health include acute illness, accidents or injuries. As a result of these, individuals might find themselves unable to work and in need of care, which will, in turn, impact their professional life.
When it comes to people’s work life, the risk of losing their job or becoming unable to work represents a major concern. Unemployment is associated with a large number of risks. Among these, the loss of income has a particularly severe impact on people’s life that will often have consequences for other areas of their life too.
As regards family life, there is the risk of losing a family member or having to care for a dependent relative. In particular, divorcing from or losing a partner who has been the sole earner in a family can have, among other things, serious financial consequences.
When managing their personal finances, individuals encounter many different risk factors as well, such as having to pay unexpected expenses. Taking out a loan also involves certain risks: If individuals borrow money on a variable interest rate, they could see their interest payments go up due to changes in market conditions and interest rates. Another risk is that borrowers might lose their job and will no longer be able to repay their loan installments as a result of their loss of income (see also Loans and loan costs). Furthermore, investments come with a number of risks: When investing in physical assets such as real estate, individuals should bear in mind that it might prove difficult to resell those within a specific time and at a desired price. In addition, physical assets can diminish in value or be at risk of theft or damage, as might be the case with motor vehicles. Investments in financial products might fall in value too, for example due to fluctuations in returns, current economic developments, foreign currency risks, inflation or other changes in financial markets. All of that being said, investing in physical assets and financial products still offers the chance of benefiting from capital gains.
Individuals also face a variety of climate-related and environmental risk factors. These include natural disasters such as earthquakes or extreme weather events such as floods, droughts, storms, hail or mudslides, which are becoming more frequent as a result of climate change. Climate-related and environmental risks can have a significant impact on many areas of people’s lives, affecting their health due to extreme heat, harming their finances or causing damage because of severe weather.
Technological risks can arise from technological progress, among other things. Advances in artificial intelligence, for example, might lead to jobs being threatened or cut altogether. At the same time, these advances create new opportunities, allowing new roles to emerge by helping automate routine tasks.
Risk attitude
When dealing with the risks mentioned above, it is important that we act according to our personal risk attitude. After all, our Risk attitude has a significant influence on the decisions we take in everyday life. We might have an appetite for, or an aversion to, risk – two concepts whose boundaries are fuzzy.
People who have a high risk appetite are more willing to accept uncertainties and take risks in order to exploit potential opportunities. They tend to go for the risky alternative when taking decisions, be it about work, finances or leisure. In other words, risk-seeking people often prefer those options that increase their chances (of profit) but also come with a greater risk of loss.
Risk-averse people, on the other hand, tend to avoid uncertainties and risks by choosing the safe alternative. To minimize potential losses, they often prefer those options that are associated with lower risk but also with limited chances (of profit). People’s attitude toward risk can play a role in decisions relating to their career, investments and personal life. As a case in point, risk-averse people prefer making detailed plans rather than leaving things to spontaneity also in everyday life, since the latter usually goes hand in hand with higher risk.
It is crucial that we carefully consider our attitude toward risk in order to make well-founded decisions in life that are in line with our individual goals and values.
Risk management
Managing risk effectively is crucial for both companies and private individuals. It can promote financial stability and enhance our personal well-being. In what follows, we present a structured approach to risk management that is often used by companies, but proves equally useful for private individuals. This approach consists of four steps: identifying, assessing, managing and finally controlling risk.
Identifying risk
The first step in successfully dealing with risk is to identify potential risk factors in our own lives. These may pertain to our health, career, or financial decisions, or may be linked to changes in our families, climate and environmental challenges or other circumstances potentially influencing our lives. We should all carefully think about what may cause us harm in the areas just mentioned.
Assessing risk
Once potential risks have been identified, the next step is to assess those risks: What is the impact if the risk occurs (severity of risk)? And how likely is the risk to occur (probability of risk)?
These two assessment criteria are shown in the risk matrix displayed below. When looking at the matrix, we clearly see that we should primarily deal with those risks that have a major impact and high likelihood of occurring.
Managing risk
When all the risks have been assessed for impact and likelihood, we have several options for taking action:
Avoiding risk
We can avoid risk by refraining from certain activities that are associated with risk. Following this, risk-averse people, for instance, would choose not to invest in high-risk financial products.
Mitigating risk
Choosing activities that come with comparatively lower risk allows us to mitigate the risk we take. People who wish to invest their money could, for instance, diversify (Diversification) their investment portfolio (see also Spreading investment risk) rather than putting all their money in one kind of investment.
Transferring risk
Risk that threatens people’s livelihood can be transferred to a third party, for example through insurance. This allows individuals to mitigate, or even eliminate, the financial burden when damage is caused. When it comes to certain types of insurance, however, individuals should bear in mind that the earlier they take out a policy, the cheaper it will be. Conversely, the later they start, the more expensive their premiums will become. This applies, for instance, to private supplementary health insurance.
Tolerating or taking risk
Individuals can choose to take residual risk that is considered acceptable and does not pose an existential threat. In such cases, however, they should make sure to have sufficient financial reserves built up.
Controlling risk
Man sollte regelmäßig kontrollieren, ob der individuelle Umgang mit den Risiken weiterhin optimal ist. Finanzielle Ziele, persönliche Umstände und neue Lebensphasen können die Risikoeinstellung von Individuen laufend verändern und erfordern somit immer wieder einer Kontrolle, ob die Bewertung und die gewählte Strategie für den Umgang mit den Risiken eventuell angepasst werden muss. Dafür ist ein durchdachtes und kontinuierliches Risikomanagement wichtig, das es Privatpersonen ermöglicht, eine stabile Grundlage für ihre Lebensziele zu schaffen und gleichzeitig ihre finanzielle Sicherheit zu stärken.
Tip
- Regularly evaluate whether your strategy for dealing with risk is still right for your current circumstances. Changing life situations or attitudes toward risk call for constant risk management.
A brief recap
What does the term risk mean?
Risk is the possibility of a certain event or action occurring which will produce unexpected results. In all of this, chance can also play a role.
Why is risk part of everyday life?
Risk is an inherent part of our lives, as it is interwoven into decisions we take and opportunities we pursue every day.
In which areas of life can risk occur?
People face risk in different areas of life. These can include their health, career, finances or family, as well as environmental or technological issues.
How can private individuals deal with risk in their lives?
By identifying, assessing, managing and controlling risk, private individuals can successfully handle risk in their lives. This involves taking measures to avoid, mitigate, transfer or tolerate risk and regularly adjusting risk strategies in response to changing personal circumstances.
