As you help your teen to build financial foundations, one topic to weave into the conversion is financial risk. Financial risk will play a role in many decisions your teen will make about money, and it’s important to talk about the impact it can have and how they can navigate it.
Let’s learn more about financial risk, how to help your teen minimize their financial risk, and how to help them manage their emotions around financial decisions.
- Financial risk is the uncertainty around money and the possibility or likelihood of loss.
- Financial risk is often used when talking about investing, but it can be a factor in other financial areas like borrowing money.
- Some of the risks commonly associated with investing include business risk, volatility risk, inflation risk, liquidity risk, credit risk, and interest rate risk.
- Investors can reduce risk by diversifying their portfolios, minimizing volatility, and avoiding making decisions based on emotions.
What Is Financial Risk?
Financial risk refers to the possibility of losing money. Risk can present itself in a variety of ways related to your finances, including in some ways your teen may not consider on their own.
Financial Risk and Investing
First, financial risk is a term often used in investing, which is when you use your money to buy assets that can potentially grow in value. Anytime you invest, you accept some level of risk, which is the potential you will lose money.
Investment risk is a continuum, with nearly risk-free assets that are backed by the government on one end, and volatile assets that have more of a gamble-like risk on the other, Adam Scherer, a CFP and the president of Greenbeat Financial, told The Balance in a phone interview.
Help your teen understand how risk and reward are related. With riskier assets, you have the potential for larger rewards but also larger losses.
“As you move along the risk continuum, the safety piece becomes more of a question mark,” Scherer said. “For an investment with lots of ups and downs and a shorter track record, you would have to be willing to weather some of that volatility.”
Financial Risk and Borrowing
Teach teens that they will also encounter risks associated with borrowing money, including through credit cards, student loans, auto loans, personal loans, and mortgages, among others.
The risks with borrowing are the consequences that can occur when you can’t pay back what you owe. You may incur interest, face penalties or fees, or lose your assets. For example, when a loan is secured with collateral like your home, a lender can seize the collateral to recoup their losses if you don’t repay them. In this case, the risk of borrowing money would be losing your home.
But even if you can afford to make your loan payments, you’ll face other financial risks, including the opportunity cost of what else you could do with that money. For example, people who carry significant student loan debt may not be able to secure a mortgage to buy a home.
Other Forms of Financial Risk
Financial risks also include the risks that come with not having a secure financial foundation, Kia McCallister-Young, Director of America Saves, told The Balance in a phone interview. For example, if you don’t have enough emergency savings, unexpected costs like a car repair or hospital bill could push you into debt.
“Make sure you have a checking and savings account, are actually saving, and have a portion of that income go to savings to build an emergency fund,” McCallister-Young said. “And make sure anything you’re planning to do that’s riskier is not at the expense of your safety net.”
You and your teen can discuss how insurance can lower financial risk. Show them how paying for different types of insurance policies like home insurance, car insurance, and health insurance, can help them avoid significant financial loss.
Risks Associated With Investing
Investing your money to earn profits entails taking on some level of risk. Let’s look in more detail at some common risks associated with investing.
Business risk refers to the risk of investing in a particular company. The price of a company’s stock depends in part on how the company performs.
If the company underperforms or goes out of business, then the investors suffer financial losses. On the other hand, if the company performs well with strong sales and profits, investors usually see gains in stock prices.
Volatility is the amount and frequency of price changes. For example, a company’s stock could swing significantly for many reasons, including as a result of its quarterly financial reports or company news. Broader market volatility can be the result of what's happening in the economy.
Investors must consider the volatility of the assets they invest in. Some volatility is inevitable. With more volatile assets, your risk of losses is higher, although so is the potential for gains. A stock may have short-term volatility but make long-term gains.
Inflation is the increase in the prices of goods and services. Inflation decreases the purchasing power of your money. For example, if you have $100 and a 5% inflation rate, your $100 would only be worth $95 the next year.
The risk of inflation with your investments is that they won’t provide a return that’s high enough to match or beat the inflation rate when you are ready to cash them out, say for retirement. When your investments earn money at a rate that is lower than the inflation rate, you are actually losing money.
Inflation risk is actually more prevalent with what we would generally consider low-risk investments such as fixed-income assets since they have historically lower returns.
Liquidity refers to how easy or difficult it would be for you to buy or sell a particular asset. The more liquid an asset is, the more easily it can be bought and sold.
Liquidity risk is the risk you won’t be able to sell your assets when you want to. For example, real estate can be considered an asset that is less liquid because of the amount of time it takes to sell.
Credit risk is the risk that a borrower won’t make its payments. As an investor, you might encounter credit risk, also known as default risk, when you invest in bonds. You’re subject to the credit risk that the bond issuer won’t pay back its debts.
To give you an example of credit risk, let’s look at it from a lender’s perspective. When you take out a credit card and spend money, the credit card company is subject to credit risk, because there’s always the chance that you won’t make your credit card payments.
As an investor, you can face the same credit risk as a credit card company when you invest in debt.
Interest Rate Risk
Interest rate risk is one you could face if you invest in bonds. It refers to how changes in interest rates can affect the value of a bond.
Suppose you purchase a bond that pays an interest rate of 1.5%. Then, market interest rates rise, so new bonds have rates that are 2%. As a result, you’ll have a more difficult time selling your 1.5% bond. You won’t get as much money for it in a secondary market since investors can buy new bonds with higher interest rates.
How To Minimize Financial Risk
As teens learn about how risk plays a role in their life, it’s also important to talk to them about ways to minimize their risk.
Build Your Financial Foundation
“Think about making sure you have the building blocks of financial stability and that you have a good understanding of financial literacy,” McCallister-Young said.
Experts generally recommend laying down a financial foundation of budgeting, saving, and more before moving on to making money through investments.
“There’s a lot of talk about young people starting to invest early,” McCallister-Young said. “But you want to make sure you have the basics down first and understand how to save before you jump into the more high-risk moves like taking out a loan and investing,”
Diversify Your Portfolio
One of the most important steps you can take to minimize your investment risk is to diversify your portfolio.
Asset allocation is how your money is invested in different assets. The more variety in your assets, the lower your risk. That’s because if one investment fails, gains in the others can potentially offset the losses. Scherer recommends choosing stocks in companies of different sectors, sizes, and countries.
Don’t Try To Beat the Market
Today there’s more information available than ever before. While that’s a great thing in many ways, it also leads to investors, especially young investors, learning about more advanced investing strategies that may be too risky for them.
“We’re growing up in a society that gives you the inclination that you can be smarter than or beat the stock market,” McCallister-Young said. “The first thing to know is you aren’t going to beat the stock market.”
Teens can still experiment with their portfolios and try advanced investing strategies they learn about. But they should understand the risks and potential losses they could face.
If teens want to experiment, for example with investing in cryptocurrencies, teach them about also having a portfolio in place that aligns with their goals.
Financial Risk and Your Emotions
It’s impossible to talk about financial risk and investing without also discussing the emotional component. After all, when something dramatic happens to your teen’s investments or another area of their finances, they are likely to have an emotional reaction. Talking about the role of emotions in investing may prevent them from making costly mistakes.
Investors, especially new investors, often make emotional financial decisions when the market is declining. They may panic or fear more losses. When the market is rising, investors may react out of greed or fear of missing out on gains.
“When things are really down, people will feel the pain of that decline,” Scherer said. “And they’ll buy into and sell out of their investments at the absolute wrong time, which is a risk to their overall ability to fund their retirement or save for legacy goals later in life.”
To avoid making emotional decisions, Scherer recommends having an investment policy statement that outlines your financial goals and risk tolerance.
Help your teen understand how to find a balance between avoiding excessive risk while still taking on enough risk to achieve their target returns. Explain how their risk tolerance may change throughout their life.
Younger investors can typically take on more risk because they have more time to weather the ups and downs of the market. Older investors nearing retirement usually have a lower risk tolerance as preserving their money is their priority, not making gains.
“The good thing about starting young and learning to invest is you have time on your side,” McCallister-Young said. “There’s always time to course-correct.”
Finally, ensure your teen knows the value of having people in their life they feel comfortable turning to for financial advice, whether it’s a financial planner, friend, or family member. And keep an open line of communication with your teen about money yourself. That way, they can see you as a resource and feel comfortable expressing their emotions and thoughts about financial topics.
“Have people around you whom you can ask questions, people who you actually trust,” McCallister-Young said. “Have your own board of directors that you can count on to ask questions and learn from instead of trying to go it alone.”
The Bottom Line
Financial risk is inevitable. As you’re talking to your teen about money, teach them about financial risk, its role in their finances, and how they can manage it.
Financial risk will be critical for your teen to understand as they start investing. Have discussions about how to build a solid financial foundation with a simple, diversified portfolio that doesn’t seek to beat the market. Help them learn to identify and manage emotions – and be there as a sounding board for them.