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Risk Management

Dealing with financial risk

Tue, 10 Jan 2012 12:00

Everybody who deals with money and finances – from business owners and banking professionals to investors and CFOs – must understand the basic principles of managing risk. Here is a brief guide to understanding risk in the financial sector.

Assess

The first step of managing risks is finding and defining them. Using your knowledge of your job, industry and unique position, make a list of everything that could potentially affect your finances – everything you can think of, from the trivial (an employee loses a hundred rand from the petty cash) to the severe (the petrol price shoots up). In the initial brainstorming phase, don’t limit or critique your ideas; just get them down on paper.

Once you have a definitive list, organise each factor on a chart where one axis indicates how probable a risk is, and the other shows how damaging the risk would be. Some risks are very probable but essentially harmless, while others could be devastating but are extremely unlikely to occur. Most will fall somewhere in the middle of this spectrum.

Now, prioritise the risks, starting with those that are the most probable and harmful, through to those that are extremely unlikely and will have a negligible effect (you can safely ignore these and focus on the more serious points). Once you have this ranking, apply one or more of the following risk management approaches to each risk.

Avoid

Often, it is best to simply avoid a risk entirely. Avoidance means creating conditions that make it impossible for the risk to occur. For example, if you don’t want to deal with the risk of a volatile investment, simply don’t invest in it and remove it from your risk profile completely.

However, avoidance is not always practical or desirable. Some risks are unavoidable – the exchange rate, oil price and economy will fluctuate no matter what you do. In addition, a lot of financial processes rely on a certain degree of risk; if you choose to eschew the uncertain investment, you avoid the risk – but you also lose the potential to earn a big profit. Therefore, avoidance should be employed for those risks you simply don’t want to take at all.

Mitigate

Mitigating is a lesser version of avoiding – it means reducing the impact of a risk if it occurs. The practice of diversifying an investment is a good example of this.

Hedging a lump sum on one investment is incredibly risky – your money depends entirely on the performance of that single company, which could succeed or fail spectacularly. When you diversify an investment, you divide your total risk into much smaller segments – even if one or two fail completely, the overall damage is not significant (and there’s a good chance that other investments will perform well and raise the entire portfolio).

Other potential ways of mitigating financial risk include using a fixed interest rate on debt repayments and entering into long-term fixed contracts with suppliers, where you are guaranteed to pay a set price over a certain period of time.

Transfer

Transferring risk means paying somebody else to take on a risk in your stead – in other words, by taking out insurance. Essentially, insurance means that you pay a set, certain, affordable monthly fee to guard against unknown and uncertain risks that would cost you a prohibitive amount were they to occur.

In some ways, taking out insurance is a risk in itself, since you must make monthly payments but you are not guaranteed that the risk you are insuring against will ever occur. However, if you apply the ranking metric above, you will see that transforming a large and uncertain risk into a certain but negligible cost is a wise step to take. Of course, not every risk can be insured against, and if the probability or potential damage of a risk is very high, the premium will be steep. Nevertheless, transferring risk is an important consideration to take into account.

Accept

Finally, some risks cannot be avoided, changed or transferred; they must be accepted and planned for. Accepting risk is actually an important act, because acceptance signifies acknowledgement and a positive step towards making a plan for the eventuality of the risk occurring. For example, interest rates and inflation are unavoidable factors in finance; their rise or fall can dramatically affect your profits and prospects. Knowing this, you can make contingency plans and respond nimbly to changing situations, reducing their impact on you.

The part-time University of Cape Town Financial Management short course starts on 20 February 2012. Call Nikita on 021 447 7565 or visit GetSmarter for more information about the course.