When it comes to achieving financial freedom, the recipe is very simple. Earn income, spend less than you earn, invest the excess, repeat. However, as I am discovering, this is much easier said than done; on the road to achieving my goal I’ve come across many risks that I need to control for in order to continue moving in the right direction. So in this article I’d like to share with you how I identify these risks and apply the risk-matrix framework to help me choose the appropriate controls for these risks.
What are Risks?
In the industry that I currently work in the definition of risk as defined by Department of Mines, Industry Regulation and Safety goes like this:
A risk is the chance of something happening that will have a negative effect. The level of risk reflects:
- the likelihood of the unwanted event
- the potential consequences of the unwanted event.
So what this implies is that risks are potential hazards that can cause physical harm to one or more persons, infrastructure and/or equipment.
So, in the field of personal finance and achieving financial freedom, where does this leave us? My view of the goal of financial independence is similar to that of a project. I want to achieve a particular outcome and I will need to take action to achieve this goal, this implies that there will be risks that could have a negative impact on me achieving my goal.
Risk Identification
Identifying risks associated with working towards financial independence is an important step towards achieving the goal. The way that I approach this problem is to break up the goal of financial independence into its components; this helps me see the individual parts of my goal more clearly, which in turn allows me to identify risks more easily. The four components of achieving financial independence are:
- Earn income
- Spend less than I earn
- Invest the excess
- Repeat
Using a risk matrix
Early in my career as an engineer in the mining industry I was introduced to the risk-matrix tool. The risk matrix uses likelihood of a risk eventuating and the consequences of the risk occurring in order to categorize the risk as low, medium, high or severe. The idea behind the risk matrix being that if a risk is considered too high to proceed, the team must put controls in place to reduce the consequence and/or the likelihood in order to reduce the risk to an acceptable level. In order words, once the controls are put in place, the residual risk must be “Low”.
I like the risk matrix tool for evaluating risks as it puts me in a very rational mindset when approaching personal finance risks by highlighting what I can and can’t control. It also makes me aware of the fact that in certain cases if the consequences can’t be reduced then we must find a way to reduce the likelihood.
Something to note is that I’ve modified the risk matrix in the “Likelihood”, “Risk Response” and “Consequence” categories to suit my personal finance needs. You can find the original matrix used in industry from the Department of Environment and Energy here.
As I’ve said earlier, in our industry the residual risk needs to be in the “Low” category before proceeding – this is due to the definitions of moderate consequences being centred on lost time injuries, which are clearly unacceptable. In personal finance however I feel that because we are dealing with some factors beyond our control such as markets and government regulation, the likelihood of such unfavourable changes can’t be reduced and in many cases actually present opportunity. As a result I believe that “Medium” level risks can be appropriate in certain cases. For example I would say it is likely that a diversified investment portfolio would lose 50% of its value within the next few years and take several years to recover. This implies that the consequence is “high” which would mean its risk rating is also “high”. In such cases a holistic approach to the entire finance picture is more appropriate, if we say that one of the controls is that the household is invested in such a way that they will not require the money in the next few years then the consequence of a bear market can be considered moderate or even minor from an “Earning and Saving” perspective which puts the residual risk in the medium to low category. In this case I would say the risk is acceptable.
Applying the Risk Matrix
Here are some of the risks that I’ve been able to identify in my life as well as the initiatives that I’ve put in place in order to reduce the risk.
Earning: Losing my job through redundancy
| Likelihood | Consequence | Risk Rating |
| Possible | High | Medium |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Possible | Minor | Low |
Controls
- Ensuring that my skill set is relevant to the current market (consequence reduction)
- Maintaining an emergency fund with 5-6 months of living expenses (consequence reduction)
- Diversifying income streams through a side hustle or second job (consequence reduction)
Earning: Not being able to work due to injury or illness
| Likelihood | Consequence | Risk Rating |
| Possible | High | Medium |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Possible | Minor | Low |
Controls
- Maintaining an emergency fund (consequence reduction)
- Income protection insurance (consequence reduction)
- Look after health (likelihood reduction)
Saving: Expenses get out of control for greater than 1 year
| Likelihood | Consequence | Risk Rating |
| Highly Likely | High | High |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Possible | Moderate | Medium |
Controls
- Pursue personal finance hobby (likelihood reduction)
- Visualize ideal life weekly (likelihood reduction)
- Have conversations about personal finance (likelihood reduction)
- Use automated investing to make it easier to save/invest and more difficult to waste (likelihood reduction)
- Review cash flows monthly and make adjustments if required (consequence reduction)
- Prioritize conscious spending (likelihood reduction)
Saving: Significant damage to house requiring reconstruction
| Likelihood | Consequence | Risk Rating |
| Possible | High | Medium |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Unlikely | Moderate | Low |
Controls
- Ensure that power to heat producing items is off prior to leaving house (likelihood reduction)
- Do routine maintenance on heat producing equipment such as air conditioners (likelihood reduction)
- Home and contents insurance (consequence reduction)
Investing: Unfavourable superannuation regulation changes
| Likelihood | Consequence | Risk Rating |
| Highly Likely | High | High |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Highly Likely | Minor | Medium |
Controls
- Do not rely on superannuation as main source of retirement income, use investment portfolio instead (consequence reduction)
- Stay up to date with superannuation changes (consequence reduction)
Investing: Portfolio loses value during a market correction
| Likelihood | Consequence | Risk Rating |
| Highly Likely | High | High |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Highly Likely | Minor | Medium |
Controls
- Consider probable worst case scenarios of double job loss during a market correction – adjust savings account to suit such that the portfolio will not need to be liquidated (consequence reduction)
- Adjust debt levels to reduce cost of living (consequence reduction)
- Understand cash flow using budget (consequence reduction)
- Focus on conscious spending (consequence reduction)
Investing: Portfolio loses value close to financial independence date
| Likelihood | Consequence | Risk Rating |
| Likely | High | High |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Possible | Minor | Medium |
Controls
- Adjust asset allocation 3-5 years out from achieving goal (likelihood and consequence reduction
- Adjust debt levels to reduce cost of living (consequence reduction)
- Consider staying in the workforce for a few more years (consequence reduction)
Repeating: Inability to repeat positive behaviours that contribute towards financial independence
| Likelihood | Consequence | Risk Rating |
| Highly Likely | High | High |
| Residual Likelihood | Residual Consequence | Residual Risk Rating |
| Possible | Minor | Low |
- Pursue personal finance hobby (likelihood reduction)
- Visualize ideal life weekly (likelihood reduction)
- Have conversations about personal finance with others (likelihood reduction)
- Use automated investing to make it easier to save/invest and more difficult to waste (consequence reduction)
- Review cash flows monthly (consequence reduction)
- Track investing quarterly (consequence reduction)
- Focus on conscious spending (consequence reduction)
Closing thoughts
Using a risk-matrix tool to approach personal finance risks is an important tool that helps me decide which risks are acceptable or unacceptable. I find that this method also guides my thought process by encouraging me to control for the likelihood and/or the consequence of the risk.
A recurring theme with my risk management initiatives involve having an emergency fund, understanding cash flows, as well as maintaining a mindset that keeps me focused on getting to my goal. To me this shows how important these 3 initiatives are to achieving financial freedom.
Regarding investment portfolio risk, this is a different topic that requires another set of articles to explore, that I’ll be writing in the future. This is due to the fact that when it comes to investments the risk-to-reward ratio is a central theme which means that the risk-matrix model is not a particularly helpful model when exploring investment risk.
So what are your thoughts on looking at personal finance risks using the risk-matrix model? Do you use it in your field of work? Or perhaps you’d like to discuss some of my ratings? I look forward to hearing from you in the comments below.
Engineer your freedom
References
Department of Mines and Petroleum, 2019, <http://www.dmp.wa.gov.au/Safety/What-is-a-hazard-and-what-is-4721.aspx>, accessed, 4/11/2019
Department of Environment and Energy, 2019, <https://environment.gov.au/system/files/pages/c6425d63-9115-4515-bef5-94f7c3bfd98a/files/risk-matrix.xlsx>, accessed 6/12/2019