What Are the Five Types of Financial Risk Management?

EP Wealth advisors can help you understand some risks related to market, credit, liquidity, operations, and legal matters. Contact us for personal or business financial planning guidance.

No one wants to lose money because of a wrong personal or business decision. Yet, everyone with a dollar to their name is susceptible to some kind of risk. Last year, America’s billionaires lost $660 billion collectively.

Fortunately, you don’t have to be Elon Musk or Jeff Bezos to work with a financial planner who can help you make informed decisions. The blanket term “financial risk” covers many different categories, which we’ll outline below.

1.   Market Risks

Generally speaking, most financial risk can be caused by movements in the market—which, in turn, are affected by a variety of factors. Some market movers include:

• The prevailing macroeconomic environment
• Supply and demand fluctuations or imbalances
• Variations in the price of assets, liabilities, derivatives, or currencies
• Interest rates
• Events such as geopolitical tensions or natural disasters
• News headlines
• Investor sentiment

2.   Credit Risks

At some point, some of us will need to borrow capital to grow our investments. Maybe you need a home equity loan for improvements that may increase your property’s market value or a juice loan to fund a business expansion. The need for funding creates a financial risk for investors and stakeholders.

Credit risks include:

• Default risk – the potential for failure to fulfill one’s obligations
• Counterparty risk – the potential for the other party in a financial deal to not meet their obligations.
• Interest rate risk – rising rates can adversely affect current loans with variable rates and future loans if high rates persist during the financing period.
• Retail risk — risk arising from consumer loans like mortgages, credit cards, or personal loans
• Wholesale risk — risk arising from business loans for funding company operations, facilitate company mergers and acquisitions
• Collateral risk - the potential for fluctuation in pledged assets to impact the terms of a loan
• Industry risk – possibility that credit access is hindered by shifts in industry-specific conditions
• Sovereign risk — strained foreign exchange policies

3.   Liquidity Risks

Liquidity means you have sufficient cash flow on hand as it’s needed — to cover day to day expenses and emergencies, pay off debts, make investments, etc.

Liquidity is a big consideration when choosing where to store your wealth. For instance, having $50,000 in your savings account offers much greater liquidity than holding $50,000 in real estate or a business, which can take time to convert into readily available capital resources.

Additionally, when dealing with assets of limited liquidity, executing transactions at equitable prices can pose challenges. For instance, there may be insufficient prospective buyers for your sales offerings, leading to asset liquidity risk. Conversely, you might encounter scarcity in potential sellers for items you aim to purchase, resulting in funding liquidity risk.

4.   Operational Risks

In business, lack of controls, flawed business models, and mismanagement can lead to operational risk — and almost certainly financial devastation for the company.

Ideally, businesses will take a number of proactive steps that limit the potential for operational failures — like appointing experienced managers, investing in the latest software, training staff adequately to avoid human error, implementing internal controls, or routinely auditing to protect against fraud.

5.   Legal Risks

Whether in your personal or business affairs, lawsuits can put your finances at risk. A legal risk may be associated with negligence or a deliberate failure to comply with client obligations.

Worst of all, a high-profile lawsuit can jeopardize your reputation and future earning potential. For this reason, some companies and high-net-worth individuals have lawyers on hand to mitigate their legal liabilities proactively.

How To Manage Financial Risk

Aside from working closely with a lawyer, you’ll want to have someone in your corner with expertise in financial planning and/or business planning.

Unlike governments, you can’t just issue bonds to fund your operations. At EP Wealth, we can help you analyze risks associated with long-term investments through:

• Fundamental analysis: the measurement of a security’s value through evaluating the underlying business dealings, assets, and earnings
• Technical analysis: the evaluation of securities through historical returns, trade volumes, share prices, and performance data
• Qualitative analysis: provides insight into factors that are not easily quantifiable but can still have a significant impact on an investment's potential success like industry trends, competitive positioning, and overall market perception
• Ratio calculations: the consideration of financial ratios like debt-to-capital or cashflow-to-capital expenditures ratio when determining potential investment risks
• Statistical analysis: the development of statistical projections based on historical trends, comparisons, current growth, and potential disrupting forces
• Goal setting: the discussion of your current growth goals, risk tolerance, and future expenses
• Hedging techniques: methods to offset exposure to various risks, often by making a counterbalancing investment

Learn about Your Financial Risk with a Trusted Advisor

No one is immune to financial risk. The best we can do is to manage it — thoughtfully, routinely, and as objectively as possible.

While many complex forces are at work — some of which are beyond any one person’s control — working with a financial advisor puts you in the driver’s seat, so you can be proactive and make informed decisions based on your needs and risk tolerance level. Contact our advisors at EP Wealth to get the conversation started today.