Managing Your Family's Financial Risks

With their middle class status growing harder and harder to maintain, many people find themselves worrying more about the financial risks they face. Too often, these worries appear as fleeting thoughts that cause a sharp rise in anxiety before they disappear (or are forcibly pushed out) of our minds. What most people are missing is a sense of control over the risks they face. With that in mind, we offer the following framework for thinking about them. While this won’t make the risks go away, we hope that it will give our readers more of a sense of control over them, and in so doing reduce the anxieties they create.

Broadly speaking, an unexpected reduction in your family’s economic well being can come from four different directions: a fall in your income, a rise in your expenses, a fall in the value of the assets you own, or a rise in the value of your liabilities. Let’s look at each of these in turn, and what you can do to mitigate the risks they pose.

As a society, we do a pretty good job of helping people hedge the risk of an unexpected fall in income. For example, governments provide unemployment insurance, and both employers and the government (via Social Security) provide disability insurance. Governments further cushion the potential impact of a loss of income via the provision of subsidized housing and food, and the earned income tax credit. Finally, both the private sector and the government (again, via Social Security survivor benefits) provide various forms of life insurance to hedge the impact of premature death, as well as lifetime annuities to hedge the risk of outliving one’s assets after retirement.

At the individual level, we can also reduce risks in this area through continuing education and networking (which help maintain our employability), as well as by building up an emergency fund of liquid savings that can be used to temporarily cover a short term income loss.

The second major threat to our economic well being comes from an unexpected increase in our expenses, which can also be thought of as the sudden appearance of an unexpected liability on our balance sheet. Most of the major potential sources of these unwanted surprises can be hedged via insurance. For example, car insurance typically covers both potential liability judgements (that is, payments to others to cover damages they sustain in an accident involving you), and collision damages (payments to repair damages to your vehicle). Similarly, house insurance typically covers both potential liability judgements, and casualty losses from fire, theft, and the like. Finally, health insurance generally covers a substantial portion of unexpected increases in our expenses in this area. Beyond insurance, we can also take other actions to limit our exposure to risks in these areas. Examples of these include driving carefully, keeping household systems (electrical, plumbing, etc.) and maintenance up-to-date, and sticking to a healthy diet and exercise plan.

The third threat to our economic well being is a sudden decrease in the value of our assets. When it comes to our financial assets, perhaps the best hedging approach is to maintain a well diversified portfolio. More narrowly, from time to time it may be possible to further hedge the value of specific financial assets or asset classes by buying put options on them. On a long term basis, however, this is generally a far more expensive strategy than diversification. When it comes to our real assets (e.g., house, car, jewelry, etc.), our options are much more limited. While casualty losses (fire, theft, etc.) can be insured against, declines in market value generally are much more difficult to hedge. Until instruments that perform this function are introduced (and they have repeatedly been discussed when it comes to real estate values), our best bet is to choose our real assets wisely (e.g., buy a house in a town and neighborhood where values are expected to increase; study resale values before buying a car, etc.).

The fourth threat to our economic well being is an unexpected increase in the value of the liabilities on our balance sheet. For most families, there are three of these: mortgage debt, installment debt (credit card and car loans), and the expected future cost of children’s college educations. Thus far, only one of these risks is easy to hedge. In the case of mortgages, we can limit the risk of a sudden increase in interest rates by obtaining a fixed rate loan, or, alternately, a floating rate loan with some type of "cap" which limits the maximum rate of interest we have to pay. Car and credit card loans are more problematic. While the former are often made at a floating rate, the latter are not. In this case, our best hedge is to limit our credit card debt when interest rates are rising. Finally, in the case of college costs, a few states offer "prepaid tuition" plans that effectively "lock in" a portion of future costs (usually tuition, but not room and board), but these are typically only narrowly applicable to state colleges and universities. Unfortunately, the ideal plan – that is, one which enables you to lock in the future cost of college, while keeping the choice of which college to attend open – has not yet made its appearance. Until it does, the best advice is to start saving early, and make sure you thoroughly understand the financial assistance options (grants, scholarships, loans, etc.) that are available to help pay for your children’s college educations.