What is ‘Risk Management’?
In the world of finance, risk management is quite simply the process of identifying, analysing and mitigating or just accepting the element of uncertainty in investment decisions. The management of risk typically occurs when an investor analyses the potential for a loss in an investment decision and then proceed to take appropriate action largely depending on investment objectives and risk tolerance. (How much the investor is willing to lose if something goes wrong).
Risk management is not something that is said just to sound superior in the financial world; it’s practically used by everyone who intends to invest for a greater return in the future. An example of its use is when investors opt for an often safer government bond over riskier corporate bonds; or when a bank performs credit checks on individuals before issuing a line of credit. It makes sense to not want to lose any money; (hopefully, by the end of this article, it should give you a rough idea of how to proceed with your next investment.)
Not having adequate risk management can result in major consequences for companies, individuals and for the economy. A more notable example would be the subprime mortgage meltdown that occurred in 2007; which essentially stemmed from really poor risk management decisions; whereby lenders who extended mortgages to individuals with a poor credit, and investment firms who bought, packaged and resold these risky mortgages really wasn’t a good idea.
Risk Explained Further
The term ‘Risk’ is often thought with many negative connotations; however in investing, ‘risk’ is a must and inseparable from the performance of the end result.
Investment risk is more commonly expressed as a deviation from an expected outcome of the investment. The deviation can be positive (good) or negative (bad) and is often related to the common reference of “no pain, no gain“; for an investor to achieve higher returns, they must accept more short-term risk; in the general sense of volatility. How much volatility? That depends on your risk tolerance; which is based on your financial circumstances and your propensity to carry the investment forward and of course taking into account your psychological comfort with the possibility of incurring large short-term losses; if the decision you make turns out to be incorrect.