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Risk and Reward: Making Decisions about Personal Finance
Understanding Financial Risk and Reward
The risk / reward spectrum
The products you choose depend partly on your risk profile. This in turn depends partly on factors like your personality, your financial situation and your age – it may vary according to the stage you have reached in life. As we age, we tend to become more risk averse.
It can also differ according to the nature of a life event – for example, someone who needs money quickly in an emergency is less likely to consider the risks of borrowing the funds.
The amount of risk faced by someone in terms of a given situation is calculated by looking at the joint effect of the probability of the risk happening and the impact and severity of that risk if it does occur. So, before a person chooses a product to fulfil a want or an aspiration, they need to consider what risks they are taking and how great these risks are. They can then choose a product that carries the amount of risk appropriate to their risk attitude and situation.
It is important to remember that all financial products carry some risk and there is no risk-free savings, loan or insurance product. One of the reasons why some people get into financial difficulties is that they are not aware of the impact a particular loss might have on their financial position and are therefore unable to manage that loss if it happens.
The greater the risk someone takes, the greater the reward they want to receive. Looked at the other way around, someone who wants to receive a high rate of return for a savings or investment product must be prepared to take a greater risk to achieve it.
How much a person is prepared to risk in their financial plan is closely linked to how much they are prepared to lose. Someone who chooses a savings account in a trusted bank knows that they will receive a low interest rate but this is balanced in their mind by their belief that their money is safe. They give up a higher return for peace of mind. They are not prepared to take the chance that they might lose their savings.
Someone who chooses a riskier investment has a different view of the balance between risk and reward. They do not want to lose their money, but they are prepared to take a higher risk to have the chance of a higher return; in their mind they balance the risk against the reward.
So, there is a spectrum of willingness to take higher levels of risk, with people who want safety and accept a low return at the one end, and people who want to earn a high return and accept a high risk at the other end. Where an individual person stands on that spectrum depends on several factors:
How life-cycle can impact your willingness to take risk
A young single person with no dependents might be willing to take quite big risks to have the chance of gaining big rewards, depending on their personality, as they have more time at their disposal to build up their capital again if they make a loss. They also have more time to give an investment product a chance to make a gain: if the stock market falls after they buy the product, but they are willing to hold on to it, the market may rise again and they may recoup their original loss.
However, a middle-aged married person with dependent children and a large mortgage would be more concerned about sustaining a loss and would probably choose a less risky form of long-term savings.
The Impact of External Factors
Your financial decisions can be influenced by a number of external factors. To a large extent external factors are beyond your control and they are factors which affect many people. For example, a period of low economic growth will result in people losing their jobs and being unable to pay their bills. Those who are still in work may decide to borrow less.
External factors affect people’s wants and aspirations, their plans and their ability to succeed in those plans. They make a difference to financial planning but people do not have direct control over them.
Inflation
Inflation is the gradual increase in the general level of prices in an economy over a period of time and it reduces the value of money that an individual has. Inflation affects different people in different ways and to a different extent. The main factor that affects an individual is the extent to which their income can keep pace with price increases. If their income lags behind, they might find themselves unable to fulfil saving or spending plans or to make loan repayments.
Inflation affects savers and borrowers differently, depending on the difference between the inflation rate and the interest rate being received or paid. Savers’ money loses value as prices rise and their position depends on whether the interest rate they are receiving covers the rate of inflation.
Inflation might affect a decision on whether to finance a purchase by saving up for the item or borrowing the money. Someone who decides to save for it faces the risk that the price of the item will rise by the time they are able to afford it, even taking interest receipts into account. It might be better to borrow the money and to buy at today’s price. The final decision will depend on the interest rate on each product.
Interest rates
Interest rates change according to the economic and financial condition of the country. Bank rate affects other interest rates, i.e. the rates that providers pay on savings and charge on loans. Saving and borrowing decisions will depend on the current level of interest rates and on how people expect interest rates to change in the future. Interest rates are closely connected with the rate of inflation, as was explained in the previous section.
Unemployment
If the level of economic activity in the country slows down, some people in jobs will be made redundant and fewer new recruits will be taken on. This has serious implications for those without jobs as they are now reliant on benefits, which are probably significantly less than the income they have been earning. They will have to reduce their spending and are unlikely to be able to save. If they have signed up to a savings scheme whereby they make a monthly deposit, they will be unable to keep this up and may lose interest. They are now not in a position to be able to borrow money.
Unemployment is a particular problem for anyone who already owes money because now they will have no income from which to meet the loan repayments. Unemployed people may have to use their savings to pay their current expenses and their debts and will probably have to postpone any life events they were planning. There is also an impact on long-term plans such as pensions.
Two Key Steps to Help You
- Emergency Fund
You should aim to put aside for an emergency fund. By saving any extra income to make sure you can access money instantly in an emergency. The recommended emergency funds are equivalent to mandatory and essential expenditure for three months. However, if you have expensive debts you may need to consider having a smaller amount of savings and repaying your borrowing first. - Diversified sources of Income
Having diversified sources of income is important, especially in the case that you you’re your main source of income. If you have diversified sources of income these will help even if they do not amount to a monthly salary.
Financial products to protect you
Unforeseen events can have negative impacts on you and your family. There are steps you can take to mitigate the impact through a number of different financial products. There are a range of insurance products available to provide protection for you or your loved ones. Insurance products can cover a wide range of unexpected events including:
- Critical illness insurance: Paying out a sum of money or monthly amount should you become ill and unable to work
- Income replacement insurance in case you can’t work through illness, or unemployment
- Life insurance that pays out a sum of money in the unfortunate case of death. This gives peace of mind that your family will be provided for
At FAB Insurance we have a range of products that can help you when the unexpected happens to give you and your loved ones’ peace of mind.
Living beyond your means
If you don’t budget or manage your money, you may find that you are ‘living beyond your means’ ie your income does not cover your outgoings. Signs that you might be in or heading for financial problems include:
Once you put your budget in place and monitor this over some months, you will get a picture of your earning and spending pattern. You will be able to see if you are in unmanageable debt.
Acknowledging that you have unmanageable debt is the first step to moving towards a solution.
Why it is important to repay debt
You will usually pay more interest on your debt than you can earn on savings. So, using extra money to reduce the cost of borrowing means you are better off overall. The most expensive borrowing products are usually credit cards or store cards, followed by overdrafts and loans.
Debt can negatively affect your credit rating score and stop you obtaining types of credit such as a credit card or loan, it can prevent you from buying things you aspire to have like a house. Debt can also significantly impact your mental health through money worries and have a negative impact on your relationships.
Failure to pay can have negative consequences. When you enter borrowing contracts you are agreeing to a legal obligation. The consequences of not making repayments on time and in full are that the you may be unable to borrow elsewhere or may only be offered products with high APRs.
For example, Ahmed signed a credit agreement when he applied for his credit card. He has been repaying the minimum amount each month and now owes AED 32,000. In the last six months he has missed two repayments. His credit card provider, Eazy Credit Cards has raised the minimum payment for the next repayment to AED 800 and warned him that if he does not repay in full within 12 months it could take him to court to recover the money. Ahmed wants to switch to another credit card with an introductory 0% APR on balance transfers but the provider he applies to rejects his application. He thinks this is because of his credit history.
Dealing with debt
If you fall into debt there are several actions that you can consider to help you including:
Trying to increase your income
- Selling an asset such as a car or jewelry and using the proceeds to repay debts
- Claiming all the benefits you are entitled to
- Taking on more work or seeking other income streams
Getting help and advice
- Contacting your bank for help
- Getting free, impartial advice from debt organisations
- Creating a debt management plan to calculate what you can afford to repay and changing products or negotiating agreements with lenders to repay a smaller, affordable amount each month
- Prioritising debts in terms of the consequences of not repaying and the cost of the borrowing (Annual Percentage Rate- APR and fees)
- Consolidating your debt into one loan
Obtaining advice about debt
Free, impartial advice is available for borrowers from not-for-profit debt relief organisations. There are other organisations that offer advice for a fee. Paying a fee will reduce the amount of money you have to replay lenders, however it can can provide further support in the long run by creating a financial debt management plan.Six steps to help you with debt management
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If you have debt problems you should find out exactly what you owe in total and to individual creditors, and check when each debt is due to be paid
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The next step is to draw up a budget to monitor outgoings and prevent further debts. All the major banks provide budget planner templates
03
Debts can then be put in order of priority: rent or mortgage arrears should come first, followed by gas and electricity. Deduct the cost of food and other necessities and then see how much is left over to pay debt arrears. Work out a realistic debt management plan.
04
Find out what interest rate you are paying on your loans. You should pay off the most expensive debt first and close the account, while at the same time keeping up the minimum repayments on the cheaper debts (if possible).The most expensive borrowing is usually credit cards and long-term overdrafts.
05
Check if you can transfer the most expensive debt to another product with a lower interest rate. For instance, several credit card providers offer an interest- free period to people who transfer their balance.
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