In life, there is no reward without risk. They are two sides of the same coin. In finance, too, there is a return only if you are willing to accept the risks that come along with it. But how much should you be willing to risk for a reward? Should you go in blind or without a plan of action? These questions should be at the forefront of your mind.
Cue: Risk Management
The concept of risk itself is evolving with changing times and its new demands. As the world becomes more connected, the potential of risk exposure magnifies. The Global Financial Crisis of 2007-2008 showed us the flip side of risks in the globally-connected financial world. It is no wonder that risk management has become an integral part of the curriculum in financial management and even CFO Executive Programs.
If you want to protect your organisation’s finances without giving up opportunities, this article is just what you need!
Read on to learn more about risk management in finance and take the first step to row your organisation to financial success.
What is Risk?
Put simply, the risk is the possibility of exposure to danger, failure, loss or other adverse circumstances. In the financial world, the word is more nuanced and focuses on investment risk. Risk in finance is the possibility that the actual outcome or return on investment differs from the expected or estimated outcome or return. It may include the probability of partial or total loss on the investment.
Any business or organisation faces risks from the get-go. These may include factors like market volatility, inflation, recession, bankruptcy, natural disasters, etc. However, failure or loss from risk is not inevitable. Risk management is at the core of any strategy to overcome the hurdles of risk exposure in finance.
What is Risk Management?
Risk is generally viewed negatively as something that has the potential to harm. But when risk and reward go together, like in finance, it becomes essential that we learn how to strategise to avoid harm. Risk management in finance allows you to do just that. Risk management is the strategic process of identifying and analysing potential risks and developing investment decisions that accept or mitigate them.
Uncertainties of investments are at the heart of financial risks that an organisation has to endure. Different asset classes come with their risks and rewards. You often hear, “Higher the risk, the higher the reward.” However, a sound risk management strategy can provide a competitive advantage. Risk management should be customised to the organisation’s goals and risk tolerance.
There are three steps of risk management in finance:
- Identification of risk: This step involves identifying and assessing potential risks of investing.
- Analysis and evaluation of risk: It involves determining the probability of a risk event occurring and its potential outcome. They are evaluated to establish their magnitude and impact.
- Risk mitigation: It involves the development of a systematic plan comprising methods and options to mitigate the potential risks from affecting the organisation’s goals, investments and activities.
- Risk monitoring: Risk management is dynamic and should be flexible to account for changing situations. Risks have to be continuously monitored so necessary steps can be taken to overcome them.
Risk Management Strategies
Risk can and should be managed. Rather than leaving the outcome to fate, adopting risk management strategies can help you get the rewards you seek from your investment.
Looking for risk management strategies from the winner’s playbook? Here you go.
The safest bet is not to play at all. You can cut out the probability of risk completely by choosing the safest assets.
This strategy involves accepting that risks come with the territory and are impossible to eliminate.
Sharing risks between two or more parties can help weather the probability of losses by spreading its impact. As they say, a fist is stronger than a finger.
Transferring risk to a third party, like an insurance company, through contractual means is another risk management technique.
This strategy involves minimising the losses and preventing them from spreading rather than completely eliminating the risk. It includes methods like diversification of investment.
Types of Risk Management
Risk management can be broadly classified into two types. They are:
Passive management generally mimics broader market returns. It involves following a specific market index, like the Nifty50, and identifying asset classes that have suffered a negative return in comparison through a measure known as drawdown. The beta risk of an asset is measured based on covariance.
A beta value below 1 means the asset is less volatile than the market and will decrease return capability and vice versa. Passive risk managers can increase or reduce their beta risk exposure by adopting strategies that will, in turn, increase or reduce their returns.
Active management involves adopting strategies that strive to outperform broader market returns. It exposes investment to alpha risks that go beyond the market risks. Here alpha is the measure of excess risk. Seasoned or high-risk investors engage in active management due to the risks involved. It includes strategies like position sizing, fundamental analysis, technical analysis, leveraging stock, sector or country selection, and more!
To reap rewards, you need to take risks. But risking it all without thought is not the strategy of the masters. Risk management is critical in today’s climate of financial risk exposure. It allows you to prepare for the uncertainties of risk strategically. You can protect the interests of your investment if done right.
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