18—Lever #1: Your Income (Part Six—The Risks)
The ability to generate a lifetime of income is your greatest asset
Murphy's Law states basically that "Anything that can go wrong will go wrong." (That explains why whenever I drop a piece of buttered toast, it always lands buttered-side down.)
You’re probably familiar with Murphy’s Law, but have you heard of Cole's Law? It's finely shredded raw cabbage with a salad dressing, commonly vinaigrette or mayonnaise.
I'm sorry for the corny jokes; this subject (risk and insurance) is unpleasant but necessary, so this article needed a little fun in the open.
Murphy’s Law may be somewhat true because it seems to describe how we sometimes experience life. But Murphy’s Law isn’t God’s law.
What is true is that bad things do happen to both Christians and non-Christians alike: “For he makes his sun rise on the evil and on the good, and sends rain on the just and on the unjust” (Matthew 5:45b, ESV).
But the good news for Christians is that there are no random (“chance”) forces outside God’s control that rule our lives. He promises that, “… for those who love God all things work together for good, for those who are called according to his purpose” (Romans 8:28, ESV).
We call the “chance” that bad things will happen to us “risk.” It’s simply our human way of describing the chance of something going wrong. Murphy’s Law suggests that because there is a greater than zero probability that something will happen, it eventually will. And if it doesn’t happen to you, it may happen to someone else.
Although this seems like “chance,” we know God is sovereign and controls everything. “Many are the plans in the mind of a man, but it is the purpose of the LORD that will stand” (Proverbs 19:21, ESV).
There are “fast risks” (those that come out of nowhere—they happen suddenly) and “slow risks” (those that occur slowly, developing over time, sometimes due to our actions or inaction).
Our actions have consequences. We see the sowing and reaping principle throughout scripture (Genesis 26:12, Job 4:8, Luke 6:38, Galatians 6:7-8). We can do things that increase our life or health risks, such as rock climbing and sky diving. And there are the impulsive "hold my beer, watch this" moments that can be super risky (especially if the can is empty).
Risks exist across the personal finance spectrum that can impact our Financial Life Equation (FLE) differently.
Future wealth = Starting wealth + Sum of all income (∑It+n) – Sum of all taxes – Sum of all giving – Sum of all living expenses + Sum of interest earned – Sum of interest paid, or, symbolically:
Some risks mainly affect income generation (∑It+n) and interest earned (∑IEt+n). Others impact current wealth (Wt ), which includes assets such as savings, investments, real estate, cars, etc.
In this article and the following three, we’ll only consider those that could impact our income-generating capability (∑It+n) and how to address them. (We’ll consider the others in later articles.)
Take another look at our equation above. Your income is assumed to be pretty constant or perhaps (hopefully) increasing steadily over your lifetime. If so, your future wealth should increase depending on what happens with the other variables.
However, future wealth (Wt+n) will decrease if income (∑It+n ) starts declining or going negative. If borrowing and interest expense (∑IPt+n) increase, your future wealth (Wt+n) will decrease faster because you may have to draw down savings.
That’s why doing what you can to protect your income from the risks you face is so important.
We can also calculate risk using a basic formula, which is:
Risk = Probability x Impact
In other words, risk is the likelihood that an event will occur multiplied by the impact that the event would have if it did happen. Let’s break that down further:
Probability is simply the chance that something will happen. In the context of risk, it's the likelihood that an event will occur that could have negative consequences for your income. For example, if you take a new job with a small start-up company, the probability that you'll be laid off may be greater than if you went to work for a larger, well-established company.
Impact refers to the effect that a particular event (such as getting laid off) would have on your income if it were to occur. In this context, it mainly concerns the loss of income. There can be short-term (I have to take a pay reduction but only for a year) or long-term (I sustained an injury that prevented me from doing my job) impact.
Let's say you want to start a new business. You invest $40,000 and estimate earning $50,000 in the first year. There's a 50% chance that the company will survive (a net gain of $10,000) and a 50% chance it will fail (a loss of $40,000). Is this a risky venture?
To calculate the risk, we’ll multiply the probability (0.5) times the impact of a successful investment (net income of $10,000) minus the probability (0.5) times the potential loss of $40,000. The result is:
Risk = (0.5 × $10,000) – (0.5 × $40,000) = ($5,000 − $20,000) = $–15,000
So, the calculated risk of starting your new business based on a 50% probability of success is $–15,000. This is the best-case risk scenario if the probability assumptions hold. (The best case scenario with a 100% probability of success is a net profit of $10,000 in year one.)
Is that a risk that you’d be willing and able to take? That’s up to you—there’s no one-size-fits-all answer. (I’m not sure I would.)
Another way to look at this is to consider the extremes. In the best case, you gain $10,000 in the first year ($50,000 – $40,000 = $10,000); in the worst case, you lose $40,000 ($0 – $40,000 =–$40,000).
If we compare potential losses to potential gains, the risk-reward ratio for this scenario in the first year isn’t very good:
(Potential Loss = $40,000) ÷ (Potential Gain = $10,000) = $40,000 ÷ $10,000 = 4:1
This means I risk $4 for every $1 of potential gains, which is an unfavorable risk-reward scenario, in my opinion.
However, using the risk formula, you can at least make an informed decision based on all the available information (the key variable being the 50/50 probability of success I used in the example).
Let's take this further to something more extreme. Assume you're a young married husband with two small children. The probability that you will lose your life is very, very low, but its impacts would be extremely severe.
Contrast that with an illness, injury, or surgery that rendered you unable to work for six months would also have a significant impact but not as severe as a loss of life.
The graphic below depicts the "risk continuum" (for income and some physical assets)—from less to greater based on its impact. It shows the various risks and types of insurance that can help mitigate the risks:
So what can we do?
Risk protection can be handled in different ways.
First, you can try to mitigate the risk. For example, to protect from losing the ability to work due to illness or injury, you can maintain a healthy lifestyle and take necessary safety precautions. And you can choose not to sit in a chair if there’s a bomb under it, especially during a thunderstorm.
Second, you can accept the risk, which is sometimes appropriate. You probably don’t need to worry about meteor or asteroid insurance as the probability of such a catastrophic occurrence is infinitesimally small—go ahead and take your chances.
The hard sell you get for an extended maintenance policy on the washer and dryer you just bought is an example of insurance you may not need (remember our risk equation). You can save money in an emergency fund to address such things. Just because you can buy a certain kind of insurance doesn’t mean that you should.
The third way to deal with risk is through risk transfer, which is precisely what it says: You transfer the risk (or most of it) from yourself to a third party, typically by purchasing insurance. Put simply, you are paying someone else to accept the risk.
For example, life insurance is at the far end of the “catastrophic” risk continuum. That's because the risk of an early death, particularly of the primary income earner for young families, is significant. The only way you could accept that risk and be confident that your family would be taken care of would be to save up whatever amount of life insurance you would have purchased.
Good luck with that!
Life insurance is at the extreme, but not because the probability of an early death is high (according to the Social Security Administration, a 25-year-old male has a 0.001963 (0.1963%) chance of dying before they reach age 26; that’s small).
It’s because the impact of losing a lifetime of income is very significant. Life insurance helps compensate for the financial loss accompanying the loss of life.
At the other end of the risk continuum is theft. No one wants to be robbed, but losing a watch or a car is much less severe than losing one's life. One can be replaced, the other can’t. You might even assume some of the risk for the lesser things, perhaps by purchasing a high deductible policy.
From a biblical perspective, we live in a fallen, sinful world and must understand its dangers and risks without fearing them. We try to provide and protect ourselves and our families as much as we can within our ability to do so (Proverbs 22:3, 1 Peter 5:8, 1 Timothy 5:8).
In subsequent articles, we will examine the various types of insurance we can use to mitigate the risks to our income-generating capability. We’ll also look at other types of risk in later articles about investing.
For reflection: We know risks abound in this broken, fallen world. Are you anxious or fearful about your job or your health? There are things we can do to mitigate, or perhaps eliminate, some of these risks, but they may not give you the ultimate peace you are seeking. Only God can provide what you seek. Give your Heavenly Father your burdens and trust in his love and providential care for you.
Verse: “Humble yourselves, therefore, under the mighty hand of God so that at the proper time he may exalt you, casting all your anxieties on him, because he cares for you. Be sober-minded; be watchful. Your adversary the devil prowls around like a roaring lion, seeking someone to devour. Resist him, firm in your faith, knowing that the same kinds of suffering are being experienced by your brotherhood throughout the world. And after you have suffered a little while, the God of all grace, who has called you to his eternal glory in Christ, will himself restore, confirm, strengthen, and establish you. To him be the dominion forever and ever. Amen” (1 Peter 5:6-11, ESV).