As teens start to earn and manage money, they likely will encounter financial risks when deciding how to save, spend, and invest their money. It’s imperative that they understand what financial risks are, and how to minimize them, to protect their finances.
Teaching teens about financial risks goes a long way in helping them make smart decisions in building a strong financial future.
What Is Financial Risk?
Financial risk refers to the uncertainty of losing money, typically through investments or running a business. “Financial risk can be identified by analyzing any potential threat that can cause a loss of value,” says Cory Moore, CFP, founder of Moore Financial Planning LLC in Oklahoma City.
To help teens understand financial risk, Ryan Kaysen, CFP, owner and CEO of Integritas Financial in Blue Bell, PA., compares financial risk to owning a car. “A favorite metaphor to describing risk to a teenager is about driving a car,” Kaysen says. “Sitting in your driveway, the car is exposed to very little risk. But once you start driving, you are increasing the amount of risk. Twenty or 30 mph is still very low risk, but the faster you go, the higher the chance of crashing the car.
“As a teenager, I believed my car was an investment, so I understood that the faster I drove that car, the higher the financial risk I faced because I could crash it and lose all the money I used to buy it,” Kaysen says.
Financial Risk in Investing
Financial risk in investing applies to the possibility of losing money when using money to purchase assets. While the hope is to increase your funds, there is a level of risk wherein you could lose some or all of your money instead. These investments range from relatively risk-free investments such as certificates of deposit (CDs) that are backed by the government to more volatile assets such as cryptocurrency that could fluctuate greatly from day to day or even hour to hour.
Financial Risk in Borrowing
Financial risk in borrowing refers to the uncertainty of not being able to repay a debt such as a car loan, credit card, or student loan. If you fall behind or default on payments, you could incur late fees, interest, and penalties. You could even lose the asset, such as a car. And the harm to your credit could take years to repair.
Financial Risk in the Real World
Financial risk is a possibility in many instances that affect everyone, even teenagers. Examples include:
- Running up credit card debt and not having money to pay it off
- Taking out a student loan, but not making payments
- Lending money to a friend who doesn’t repay it
- Buying stocks in a popular company, then losing that money when the company files for bankruptcy
Types of Financial Risks
Several types of financial risks could affect how teens spend and invest their money.
Volatility Risk
This type of risk often refers to stocks, whose prices can rise and fall drastically in short order.Volatility is something many adults have trouble with because it has a major and immediate impact on our emotions,” Kaysen says. “Seeing a stock jump up fast and fall even faster is like being on a roller coaster that is taking your feelings and finances along for the ride.”
Inflation Risk
This risk refers to the value of your money and how it could change in the future. “Inflation risk is the risk that the value of your dollar today will not be the same at a later date; therefore, you will not be able to buy the exact same item for the exact same price in the future,” Moore says.
Interest Rate Risk
Many investments and financial tools include fixed interest rates. For instance, a car loan may be financed at a 5% interest rate, or a certificate of deposit may have an interest rate of 3%. With the car loan, the interest rate could drop to 3.5% after you sign your loan agreement. That means you are paying more in interest on the car loan than if you had waited for lower rates.
With the certificate of deposit, say the interest rate increases to 4% after you get your CD. That means you are not making as much money on the CD as you would have if you waited for higher interest rates.
Business Risk
This type of risk refers to investing in a company, such as buying stocks. If the company closes or goes bankrupt, you could lose the money you paid for the stocks.
Liquidity Risk
This refers to trying to sell a security, but no one is buying. “A good example of this is when an investor is trying to sell a falling security, but there is no market for it,” Kaysen says. “This means the type of investment is unable to be sold quickly enough to avoid the losses.”
Liquidity risk could also refer to paying penalties when cashing out a certificate of deposit before the term ends or withdrawing funds early from an investment account.
Risk Management: How to Minimize Financial Risk
There are several ways that teens can try to determine risk and reduce it when it comes to spending and investing their money.
Have a Strong Financial Foundation
Before considering any investments, teens should have a strong financial foundation that includes knowing how to budget and manage their money as well as a maintaining a healthy savings account. Having a clear picture of their finances provides a good overview of how much, if any, money a teen can risk with investments.
Have an Accountability Partner
As they learn how to navigate the financial landscape, it’s important for teens to have someone they can trust to provide guidance regarding risk management.
“Accountability to yourself will get you started on the right path,” Kaysen says. “I encourage investors to find an accountability partner who can help them identify the risks they are not seeing. This partner should not have any financial incentive in your decision so they can remain unbiased.”
Educate Yourself
It’s important to know what you are investing in and the possible risks associated with it.
“Buying and selling stock isn’t as simple as reading a tweet that it is a good purchase,” Kaysen says. “You need to know the fundamentals of a company because when you buy a stock, you become an owner of that company. You should always invest in a company thinking that you will be buying the entire company and not just a small share. This will impress on you the importance of buying a strong and profitable business.”
Diversify Your Investments
Putting your money in a variety of financial investments and products can help reduce risk. This could include a mix of government-backed assets such as certificates of deposit, stocks, and securities.
What are financial risk factors?
These are the underlying characteristics of the investment that explain risk.
“All investments have some factors to help explain the traits of the associated risks,” Kaysen says. “Bonds, real estate, currency, commodities, and all others have their own set of factors to help you make the decision to invest or not.”
What are the types of financial risk?
These include volatility, inflation, interest rate, business, and liquidity risks.
What is a real example of financial risk?
A real example is financing a student loan at a fixed rate, then seeing the rate drop in the next few weeks. As a result, you’ll pay more in interest on the loan than if you had waited for rates to drop.
How do you identify financial risk?
The best way to identify financial risk is to review the financial information for the potential investment. For instance, if considering a certificate of deposit (CD), check the interest rates for the last few years. Have they declined? Increased? Held steady? This could indicate if the rate is expected to change after you purchase it.
The Bottom Line
Investing and spending money come with a variety of financial risks that could result in lost funds. Therefore, it’s important to learn about these risks and how to protect your money when looking to grow your finances.
By educating yourself and evaluating these risks, you could increase your finances without incurring losses.
