Knowing your financial risk tolerance is not only for people who are investing. As long as you want to make the right decisions about your finances, this is something that you need to identify. How else can you be brave in making financial decisions? You need to know if you can afford to take high financial risks before you proceed with them.
Your inability to understand the level of risk that you can take will affect you in two ways.
The first is it can lead you to make irresponsible decisions. You may think that you can afford to borrow a certain amount of money when in truth, your finances are already spread out thinly. Since you are unaware of your financial risk tolerance, you might have a false sense of courage when making financial decisions. It might lead you to sign into financial agreements that you cannot commit to.
Another way that you can be affected is through financial opportunities. If you have no idea how strong your finances are, you might miss out on opportunities that could have pushed your income or profits to greater heights.
These are only two simple explanations of why you need to understand the level of risk that your finances can afford to take.
According to an article published on Bankrate, the financial security index of the country is going down – but Americans appear to feel confident about their finances. The report revealed that Americans feel like their financial security is better and that makes them more confident when they are making financial decisions. In fact, it is the Millennials who have reported that they are the most comfortable when it comes to their financial position.
This is where you need to be very careful. Young adults are ridden with debt – specifically student loans. While it is admirable that they feel confident despite the amount of debt that they owe, it can also be dangerous. They might have a false sense of their financial risk tolerance. It could lead them to make financial decisions that they are not ready to commit to.
3 ways you can check the risk tolerance of your finances
It is not difficult to determine your level of tolerance when it comes to money-related risks. But it is important that you take the time to get to know your risk capabilities. At least, if you want to improve your finances, this is one aspect of your finances that you need to understand. There are three important areas in your financial life that you need to look into.
Your emergency fund. This is a safe place to start – your emergency fund. According to the data published by CreditDonkey.com, 26% of Americans do not have any cash in the bank to fall back on in times of emergencies. This is a bad situation to be in because it lowers your risk tolerance. If you have enough reserve funds, you can afford to risk your extra money. In case something goes wrong, this emergency fund can help you survive until you recover from your mistake. Your risk tolerance will be directly proportionate to the size of your reserve fund. The bigger the fund, the more risk you can take.
Your financial goals. Your financial decisions should always try to lead you towards your goals. If it does not, then it would not be worth the risk. For instance, if it is your dream to start your own business, then taking out a business loan should be worth the risk of starting your company with debt. If education is important to you, then student loans are worth the risk. When you take risks to reach your financial goals, failing at it will not really destroy you. It will motivate you to take on calculated risks to achieve your goal.
Your existing debt. Finally, you need to think about your level of debt. It does not matter if you have enough emergency fund or if the risk will lead you towards your financial goals. If you have a lot of debt, you cannot afford to risk your money. You need to put importance into your debt payments. You cannot compromise your current finances because defaulting on your loans will make your financial situation go downhill.
Make sure that all three are accounted for before you decide how much financial risk you can really take. If even one of these are compromised, you need to take a step back to strengthen your financial position first.
How to make your finances more secure
Of course, achieving financial security does not happen overnight. You need to work hard for it and the task before you should be given continuous effort. Here are a couple of tips that will help you strengthen the security of your finances.
Know your finances. Start by understanding your financial position. Unless you know where you stand, you would not know how near or far you are from your intended destination. Get to know your specific situation through a budget. Identify how much you are earning and where it all goes. This will allow you to determine where your money is being spent – and if it is going where you intend it to. Sometimes, we are unaware that our money is being wasted on things we can live without.
Diversify your income. This is the best way to secure your finances. If you want to increase your tolerance for financial risk, you have to diversify your income. Apart from your day job, open another source – like an investment or a side job. That way, if one source of income is compromised, you still have one that will continually provide you with money. This will give you the confidence to take on more risks – at least when your income is concerned.
Build up your savings. This is specifically referring to your emergency fund. Before you start saving for any financial goal like a new house, car, or even a vacation, make sure this fund is intact. Do not use it for anything else other than an emergency.
Establish a debt payment plan. It is okay to use credit but make sure you have a payment plan in place – all the time. According to an article published on Time.com, Americans feel like paying their credit cards in full is unusual. That is how much we have grown to be accustomed to being in debt. While debt can be used as a tool to improve your finances, it can also destroy your dreams and compromise the risks that you are taking. So when you use credit, make sure you have a plan to pay it back – and you will follow it.
Common questions about financial risk
Question: What is a financial risk?
Answer: This is anything that will compromise your financial security in a negative way. A risk is a possibility that you can lose money because of a decision or transaction.
Question: How can you increase your tolerance for financial risk?
Answer: The key is to increase your financial security – and in effect, your financial stability too. When your finances are secure, you are in a financially confident position to take more calculated risks.
Question: What causes a financial risk?
Answer: This is any decision, transaction, activity, or investment that can cause you to lose money and gain nothing. This can be caused by both internal or external factors. For instance, the risk may be caused by your own irresponsible choices or it could be influenced by the national economy.
Question: How do you evaluate your financial risk?
Answer: Evaluating your financial risk takes a calculated analysis of your past (debts), present (savings), and future (goals). A debt is a liability that can multiply the losses that you will take in case the risk comes to pass. At the same time, your savings and goals will help you decide if you can afford to take the risk or not.
Question: How important is a financial risk?
Answer: This is important because it will guide you as you take decisions. We cannot avoid making these financial decisions – but we need to be aware of our own financial capabilities before we really dive into any risk.