What is risk management?
Risk Management is the process to identify and evaluate probable potential risks and plan to take necessary steps to mitigate the losses. In simple words, risk management means to foresee probable risks that may arise while making investments and taking steps to ensure that the losses are minimized.
Risk management is an important consideration to make while making investment decisions. Not paying proper heed to this can create huge losses for investors and wreak complete havoc in their financial goals. There are several steps to effective risk management.
The five steps of risk management
Managing risks involves the following 5 steps.
Identifying the risk : This involves predicting what kind of risk may arise . The risk could be due to legal future regulatory measures imposed by the government or maybe the market rate of investments decreasing. The potential risks could even be legal or due to the occurrence of natural calamities like flood or famine. The investors need to identify what kind of risks their investment could be prone to.
Analyzing the risk : Once the risk is identified, the next step entails analyzing the risk. This means to determine how the risk will affect the investor. Also, what other parameters will get affected as a result of the risk. Some risks can be riskier than others. The investor may want to forego taking the risk and change his investment decision, if after analysis he finds that the risk is going to have an adverse effect on most other parameters of his life or company.
Evaluating the risk: It is important as a third step to evaluate the risk. This refers to ranking the risk as low risk, high risk etc. A risk that is just going to cause some disturbances is ranked low whereas one that can cause disastrous results will be ranked high. Risk analysis could be done either through qualitative or by quantitative assessment techniques.
Treating the risk: This refers to the risk being discussed at length. For an investor, it is important to know how the risk that his investments are associated with is going to impact the other parts of his life or financial well being. After a proper evaluation and analysis, an investor may choose to do the following to mitigate the risk:
a). Avoiding the risk : This means that the investor may decide that the risk is not to be taken for its potential results are catastrophic and cannot be taken.
b). Sharing the risk : This refers to roping in other organizations or individuals to share in the probable losses and subsequently the profits that the investment decision might entail. For example, when a business is insured the risks are shared with the insurance company.
c). Accepting the risk : Risks that are unavoidable will need to be accepted. For example while buying a house, the risk of the buyer could be that he may lose his life to accident or illness during the tenure of his paying the EMI for home loan. But the improbability of such and event weighed against the benefits of owning a home induces the investor to accept the risk and invest in a home.
d). Controlling the risk : This refers to accepting the risk but with preventive actions to mitigate as much as possible, the risk that is taken. For example, in our previous example, the home loan borrower may buy a term loan insurance for the entire amount of the loan to help manage the risk of his family not being able to pay the loan in the unlikely event of his death.
Monitoring the risk : The investor may accept the risk, but the fifth most important step is to continuously monitor the risk so taken. The scenario associated with an investment risk may change as markets are not stable, they fluctuate. Therefore, to monitor the decisions taken to accept or avoid risks should both be monitored.
Risk management is an important consideration in businesses and investment portfolios. The risk analysis done for an investment helps the investor or organization determine the type of risk that can be predicted and how to manage them in a way that they cause least havoc in the general functioning of financial activities and ultimately life or the health of the organization.
