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Risk Management: The What and How
- Defining Risk Management
- What goes on behind the scenes
- The reason you need risk management
- Effective risk management tactics
- A continuous process
Defining Risk Management
If you have an interest in the finance industry, you will most probably have heard the term Risk Management before. While the term may seem self-explanatory, there are many ways in which to actually implement risk management techniques in your financial work.
Let’s start at the beginning. What is risk management in finance?
Risk management can be defined as the process of identifying, assessing, and prioritizing threats to capital and income. Finding the most opportune ways to minimize, monitor, and control the impact of these uncertainties is an essential element of your trading journey. Risks can come from a multitude of sources. Therefore, the goal of a risk manager is to implement appropriate actions to mitigate or avoid these risks.
So, where does risk occur? It happens everywhere in the world of finance. We may see uncertainty looming on the horizon when an investor buys treasury bonds over corporate bonds or when a fund manager hedges his currency exposure with currency derivatives. It can also happen when a bank performs a credit check before issuing a loan, for instance.
Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio diversification, asset allocation and position sizing to effectively manage risk.
Assessing risk is essential in any business – it provides insights into the returns on investment, as well as the potential failures for a new company or project.
What Goes on Behind the Scenes
So how does risk management unfold? While the connotation to the term Risk is predominantly negative in the investment sphere, it is interlinked with high return. Experts study the deviation – a mathematical measure to quantify financial risk – whether it is positive or negative. As a result, investors accept the idea that such a deviation implies some degree of impact on the investment. Thus, to achieve higher results, one ought to accept more risk.
Along with higher risk, comes more volatility. So, risk managers and experts, seek ways to reduce this volatility – and this is usually done on a case by case approach. Since the amount of volatility that is acceptable depends entirely on the investor’s willingness to take on risk or how much tolerance their investment objective allows.
The Reasons You Need Risk Management
Assessing and managing risks is the best weapon you have against catastrophic losses. By evaluating your plan for potential problems and developing adequate strategies to deal with uncertainty and volatility, you’ll improve your chances of a successful endeavour. The best defense, is a good offense.
Why do you need Risk Management?
- Identify possible risks.
- Reduce or allocate risks more efficiently.
- Better decision making.
- Effective planning.
Additionally, continuous risk management will:
- Ensure that high priority risks are mitigated.
- Manage risks in a cost-effective manner.
- Provide information on issues that are critical to project success along the way.
Other important benefits of risk management include:
- A safe and secure work environment.
- The stability of business operations while also decrease legal liability.
- It provides protection from events that are detrimental.
- Protects all stakeholders and assets from potential harm.
- Establishes the organization’s insurance needs.
Effective Risk Management Tactics
When preparing your risk management strategy, you should first attempt to answer the following questions:
- What can go wrong?
- Will the risk event have a small or large impact?
- What can be done to prevent it?
- How will you recover?
The Risk Analysis Process primarily involves the evaluation of the problem’s nature and its solution. And while every expert can add his or her own touch to the process, the pillars of risk management are the following:
Identify the Risk
- Start off by thinking about all the possible risks and list them.
- Using an assessment tool, risks are then categorized and prioritized. The number of risks identified usually exceeds the time capacity that the project team has to analyze and develop contingencies.
- The process of prioritization helps to manage those risks that have both a high impact and a high probability of occurrence.
Assess the Risk
Problem-solving involves a move from problem identification to problem solution. However, before trying to determine how best to manage risks, you must identify the root causes of the identified risks. Ask yourself:
- What would cause this risk?
- How will this risk impact the project?
- How likely is this risk to occur?
Develop Responses to the Risk
Now get into the process of assessing potential prevention methods. Ask yourself:
- What can be done to reduce the likelihood of this risk?
- What can be done to manage the risk if it occurs?
- Treat the worst risk first
Develop a Contingency Plan or Preventative Measures for the Risk
- Develop short contingency plans to manage the identified risks should one of them occur.
- Monitor and track to identify any changes in the risk event criteria to avoid a widespread ripple effect.
A Continuous Process
In a nutshell, the risk is inseparable from return. Every investment involves a level of risk.
Once you have identified all the possible risks that may block your success, you can then proceed to filter out those that are most likely to occur. Therefore, this weighted judgement call will determine the course of action you choose.
It is crucial to keep in mind that risk management is a continuous process.
Keep in mind these 5 tips when you are formulating your risk response:
Avoid activities that have a high risk. In so doing, however, you will also forfeit a potentially high return. It is up to you to consider which risk level is acceptable to you.
Implement small changes to reduce the weight of both risk and reward. This act will save you from a severe loss in the case of a high-risk episode.
Risk-sharing or transferring redistributes the burden of loss or gain over multiple parties. As a result, this diffuses any potential risk.
Risk-retention involves assuming the loss or gain, entirely. This option is best suited for small risks where the losses can be easily absorbed and made up for.
Opportunity and risk go hand in hand and are higher during the planning phase of an endeavour. However, there are still unknowns during the execution, and new risks will surely be identified, quantified, and managed throughout the project’s life.
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