by Ben Jennings, Lead Advisor and Director of Planning Research
A little less than a year ago, friends of ours were sitting in their living room watching their favorite TV show. They heard a popping sound in the adjacent laundry room and opened the door to investigate. Their clothes dryer had caught fire! They got out of the home safely, but though the fire was relatively contained, the smoke damage made their home uninhabitable for several months, and many of their household contents had to be replaced.
You may not find it surprising that out of all my acquaintances - numbering certainly in the dozens and perhaps in the hundreds - to my knowledge these were my only friends who experienced a house fire in the last year.
You also may not find it surprising that - to my knowledge - each of my dozens of friends paid their homeowners insurance premium in the last year.
My question is: Why are those two facts not surprising to us? It seems each of my friends - with one exception last year - made a decision to pay hundreds of dollars unnecessarily! If you weren’t my friends who had the fire, why doesn’t the outcome of the last 12 months show that paying your homeowners insurance premium was a poor decision?
My answer is: In this example, we see we can’t evaluate the quality of decisions based on outcomes. (I will note this point is equally true but less easily seen in other settings, but that’s for another newsletter!) Instead, decisions are appropriately evaluated by the soundness of the process used to reach the decision.
We all face situations of uncertainty and risk which require decisions. Later this year, our planning emphasis for most clients will be how we manage the most important risks that can impact our financial life.
Here is the process we’ll use in a nutshell: For the most common risks that may affect you, we are going to consider the probability of a negative outcome, and the consequences of that outcome.
Some outcomes may be likely, but inconsequential, while others could be rare but devastating. Considering these two aspects of a given uncertainty will help us determine what combination of these four categories of risk management approaches should be used:
Avoiding the risk
Controlling the risk
Accepting the risk
Transferring the risk
Insurance (transferring the risk) is one kind of tool we can apply to financial risks, but there are “other tools in the toolbox” to consider. As we prepare to work with you in this area later this year, we are busy refreshing our processes, tools, and decision frameworks so we can advise you well and effectively. Let us know if you have general or specific questions you’d like us to address!