An indifferent person has only taken risks on financial matters. He would like to make money while sitting on the chairs. Sometimes, you would not agree with these comments because you have seen the people who were successful in life stand with vigorous efforts and hard work. But you will agree with one thing that success depends on how much risk you are ready to take. Risks and threats are inherent in all activities that you are adopting to achieve certain goals. The concept of risk management refers to identifying potential risks in advance, analyzing them, and taking precautionary steps to mitigate or control the risk.
Risk management in financial matters
In the business world, risk management is the process of understanding and finding, evaluating, and controlling threats to an organization’s capital and earnings. These fears, or risks, could originate from various sources, including financial ambiguity or uncertainty, legal liabilities, strategic management mistakes, calamities, unforeseen accidents, and natural catastrophes. In addition, data threats such as leaking of data, and cyber security problems with data management, are the new threats that stem from IT security matters.
Risk management occurs when an investor or fund manager analyzes and attempts to measure the potential for losses in an investment, such as a moral hazard, and then takes the suitable action (or inaction) given the fund’s investment purposes and risk tolerance. You have heard the wordings of stockbroking houses and fund managing companies “mutual fund investment is subjected to market risk.” Not only mutual fund investment but also every investment, even Gov. Bonds couldn’t give yields in tough times. Securities brokers use financial instruments like options and futures. Money managers use strategies like adding or deleting new stocks for their portfolio diversification, asset allocation, and position sizing to lessen or successfully manage risk.
Ineffective risk management strategies can result in severe damages for companies, individuals, and the economy. For example, the 2008 recession stemmed out from the inadequate risk management measures and decisions of lenders who extended mortgages without evaluating the actual income of the individuals; as a result, individuals lost their repaying capacity because they have suspended from their jobs.
Every business and organization faces the risk of unforeseen, unsafe events that can cost the company money or cause it to permanently close. Risk management lets establishments attempt to prepare for the unanticipated by reducing risks and extra costs before they happen. So, to reduce and control the exposure of investment to such risks, fund managers and investors practice risk management. Not giving due importance to risk management while making investment decisions might wreak disaster in times of financial chaos in an economy. Diverse levels of risk come attached with different categories of asset classes.
For instance, bank fixed deposits have been considered a low-risk category, while equity investment is a high-risk venture. However, fixed deposit only gives a fixed amount as returns, whereas equity investment could give huge returns along with the risks of melting down. Therefore, while practicing risk management, equity investors and fund managers have a habit of spreading their portfolios to minimize risk exposure.
Importance
An organization can save money and safeguard its future by applying a risk management plan and considering the various possible risks or events before they happen. It’s because a robust risk management plan will help a company create actions to avoid potential threats, lessen their impact should they occur, and cope with the consequences. In addition, this talent to comprehend and control risk allows organizations to be more assertive in their business decisions. Besides, strong corporate governance principles that focus specifically on risk management can help a company reach its objectives.
Advantages of risk management
- Generates a safe and protected work setting for all staff and customers.
- Improves the stability of business operations while also reducing legal liability.
- Offers protection from events that are harmful to both the company and the business environment.
- Defends all involved people and assets from potential damage.
- Supports establishing the organization’s insurance requirements to save on excessive premiums
Risk management methods and processes
There are standardized measures and steps to mitigate risks, these includes:
Risk identification. The company recognizes and defines potential risks that may adversely influence a specific company process or project.
Risk analysis. Once definite forms of risk are identified, the company then fixes the chances of them happening and their consequences. The goal of risk analysis is to comprehend further each specific case of risk and how it could influence its plans and aims.
Risk assessment and evaluation. The risk is then further assessed after determining its overall probability of occurrence combined with its overall consequence. The company can then decide whether the risk is tolerable and whether the company is willing to take it on based on its risk appetite.
Risk mitigation. Companies evaluate their highest-ranked risks during this stage and develop a plan to lighten them using specific risk controls. These plans include risk mitigation processes, risk prevention strategies, and contingency plans if the risk comes to completion.
Risk watching. The mitigation plan includes following up on both the risks and the overall strategy to monitor and track new and existing threats constantly. The overall risk management process should also be revised and updated accordingly.
Communicate and consult. You should include internal and external stakeholders in communication and consultation at each right step of the risk management process and favor of the process.
Risk management tactics
After the company’s specific risks are recognized, and the risk management process has been executed, there are numerous different strategies companies can take in respect to different types of risk:
Risk avoidance. Even though the complete removal of all risk is rarely possible, a risk avoidance strategy is planned to deflect as many threats as possible to avoid a damaging event’s costly and troublemaking consequences.
Risk lessening. Companies are sometimes able to lessen the amount of harm certain risks can have on company processes. It is attained by regulating certain aspects of an overall project plan or company process or reducing its range.
Risk distribution. Occasionally, the consequences of risk are shared or dispersed among several of the project’s participants or business departments. The risk could also be pooled with a third party, such as a dealer or business partner.
Risk holding. Sometimes, businesses adopt a risk is worth it from a business perspective and decide to keep the risk and deal with any potential outcome. For example, companies will often preserve a certain level of risk if a project’s predicted profit is greater than the costs of its possible danger.
Why do people reluctant to take risks
People know that without taking risks, there is only little chance to gain more. Despite knowledge of the relationship between success and risk, why should people hesitate to take risks? The field of behavioral economics has contributed an important element to the risk calculation, demonstrating unevenness between how people view gains and losses. In the view of prospect theory, an area of behavioral economics introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion. Tversky and Kahneman stated that investors put roughly twice the weight on the pain associated with a loss than the good feeling related to a profit. Thus, people are satisfied with low gains rather than high losses or keep their possessions instead of taking risks.
Limitations of risk management strategies
Different organizations are facing other challenges and threats. However, the standardized mitigation programs of risk management required unique approaches to reduce risks. So, contextual methods are suitable to mitigate risks and challenges. But most companies are looking for copybook approaches to lessen the chances this might result in financial losses. While risk management can be tremendously good practice for organizations, you should also measure its limitations. For example, risk analysis methods need large amounts of data. This broad data collection can be costly and is not assured to be trustworthy. Besides, the use of data in decision-making processes may have poor effects if simple signs replicate much more complex realities of the condition. Likewise, adopting a decision throughout the project intended for one small aspect can lead to unforeseen outcomes. Another limitation is that it is difficult to see and identify the complete picture of cumulative risk.
About the Author: Pramod Kumar
Pramod Kumar is a teacher, trainer, and writer passionate about academic writing. His favorite subjects include psychology and economics. He is always exploring innovative theories and how they can be implemented in everyday lives. He is also a regular content contributor for Slidebazaar.com, a website dedicated to PowerPoint Templates.
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