Author: Katarína Marcinová
Date of Publication: 12/01/2023
Risk management includes the identification, analysis and response to risk factors that accompany the life of a business or an investment decision. Effective risk managment is intended to mitigate risk occurrence and its potential impact. Risk management occurs in all spheres of finance: - when an investor buys US goverment bonds through corporate bonds, when a bank performs a credit check before issuing a personal credit line, even buying carinsurance is a form of risk management, as it reduces the financial impact in the event of a car accident. Risk management occurs when the fund manager or investor analyzes and tries to quantify possible losses in the investment goals and risk tolerance, appropriate measures, or inaction with regard to investment goals and risk tolerance. However risk does not necessarily mean negative phenomenon. Taking more risks brings the possibilty of more returns. Risk is simply inseparable from return. All investments certtainly carry risk, whether almost zero in the case of an American T-account or large for example, in developing markets or real estete in highly inflationary markets. The relationship between risk and return is a fundamental principle of investing. The return must alway be conceived in the context of the risk that is taken to achieve the return. Traders use different financial tools and money managers use different strategies for risk mitigation or effective risk management. Inadequate risk management could have serious consequences for an individual or company and their economy.
Responses to risks avoidance
When the company tries to eliminate a specific risk, so that it gets rid of its cause mitigation – reduction of the expected financial value, which also reduces the possibility of risk acceptance – sometimes a business entity then develops a plan for unforeseen events to mitigate the impact of the risk, should it occur. The company needs to have identified potential risks, then it is easier to mitigate them. The goal is to act proactively, not reactively. Risk management tools and techniques help to control and eliminate them so that they do not interfere with the performance and goals of the company.
Why is risk management important?
It reduces unexpected events – in addition to detecting them, it reduces potential risks, it also creates structures to deal with them, and enables them to beaddressed and their impact mitigated if the company were to be affected.
It creates financial benefits – it allows to reveal budget needs, instead of relying on guesswork, prevents recurring losses.
It enables the success of the project – it enables being prepared for the unexpected, provides a context for understanding the performance of the project, helps with health checks, investigations or audits, helps to maximize the results of the project.
Saves time and effort – alleviating the demand for predicting employe data in the event of an incident or unexpected event.
Improves communication – helps effective collaboration, offers a central point for all data and reports, which improves communication, encourages project teams, stakeholders and other members to join the discussion.
Facilitates decision - making analyzes and data facilitate the difficult decision – making process especially in the case of big decisions that fundamentally affect the succes of the business.
Important risk management plans
Brainstorming – brainstorming of team members, assesment of potential risks that would affect business and strategy planning. Brainstorming starts with checking project documentation, examining historical data, information, learning about risks, reading related articles, understanding all the assets of organizational processes. It also appropriate to contact experts, interested parties or anyone, who has experience in dealing with various risks.
Perform a root cause analysis – this technique is used soon after the problem arises, where its cause is analyzed – searching for answers to the questions: what happened, why, how... Elaborating these answers will help set an action plan, so that these mistakes do not happen again in the future.
Perform a SWOT analysis – this technique measures the strong and weak sides of the project and thus helps to identify all potential risks. It starts with identifying the strenghts of the project or company and then moves on to a list of weaknesses and other areas that require improvement.
Create a template for risk assessment – this is a template for risk assesment a numbered list of all risks will be created and thus facilitate their monitoring during the implementation of the project, if it is created in a spreadsheet, the built in calculator can also provide numerical data on the probability of risks and their impact on the project or the entire organization.
Create a model for risk assesment – a document such as a risk register or risk protocol that documents, tracks and monitors all potential risks, takes measures and steps to prevent and correct them. An excellent software helper in this case is the Bit.aj program.
Create a matrix of probability and impact – this method allows you to combine the probability score and the impact score of individual risks and then rank them in terms of severity.
Assess the quality of risk data.
Analyze variance and trends – this technique analyzes differences, deviations from plans and costs compared to actual results. As the deviations increase, so does the risk and uncertainty.
Use reserve analysis – it is very important to plan the budget for your project along with reserves for crisis measures and reserves for management.
Types of risks
As an investor, you face different types of risks:
Business risk – if the company in which you are a shareholder or bondholder declares bankruptcy, you may not be left with anythnig after the liquidation, therefore the best way is to invest no more than 5% of your portfolio in one company. Market risk – even if you invest in various financially healthy companies, you face losing money as a result of market risk, because the stock market moves. For example the security will lose its values.
Inflation risk – this risk means that your income may not keep up with inflation and your money will lose purchasing power. This risk much higher when investing in low – risks assets such as bonds and CDs.
Credit risk – the risk that the counterparty will not pay its contractual obligations – e.g. an individual who defaults on a loan. Liquidity risk – financing obligations may not be fulfilled due to cash restrictions – such as restrictions on the bank´s side.
There are different tactics for detecting risk in investment markets. Risk ussually focuses on the probabilty that the result of the investment will different from the expected result. Investment risk can be defined in several ways, including using:
Alpha: the risk that an investment strategy/portfolio will underperform relative to a related benchmark such as the S&P 500.
Beta: the volality of returns on an investment or portfolio relative to the overall volality of the broad market.
Standard deviation – the volality of returns of an investment or portfolio in relation to its average return over a certain period of time.
Sharpe ratio: the rate of return as a unit of risk for an investment or portfolio over a specific period of time to capture a return relative to the associated risk taken to achieve the return.
Let´s see it in practice
The Beta coeficient is a good way to quickly measure risk. Beta measures a stock´s volatility relative to the overall stock market, usually represented by the S&P 500. A stock with a beta of exactly 1.0 has the same level of volality as the stock market. If its beta is less than 1.0 it is less volalite. A beta above 1.0 indicates more volatility relative to the market. For example, a stock with a beta of 1.1 is 10% more volatile than the stock market. Alpha measures risk-adjusted performance. A positive alpha indicates that the assest´s return exceeded its risk, a negative alpha indicates that the return did not exceed its risk. Alpha and beta can be used together to determine whether a particular stock or fund was a good investment. For example. If a stock has a beta of 1,5 and S&P 500 rises 20% you would expect a return of 30% (20% x 1.5). But if you only earned a 25% return, the stock´s alpha is – 5% meaning you weren´t adequately rewarded for the additional risk. Understanding beta and alpha can help you gauge the historical risk of an asset, but it´s also necessary to employ a risk management strategy that projects against potential losses.