Today, many businesses are started owing to the high potential returns one is likely to gain. However, of note is that there is no return without taking on some degree of risk. Risk is defined as the “possibility of loss of the value of an asset”. Risks are a part of everyday life; even those who avoid taking risks on a day-to-day basis cannot completely eliminate it. Businesses are more so subject to risk, as risk is an underlying concept in the way businesses work, succeed and fail in their relative environments.
It is for this reason that business owners should not only understand the fundamentals of risk but also how to diversify risks. There are two main types of risk; the first is undiversifiable risk, otherwise known as systematic or unavoidable, while the other is diversifiable risk. Undiversifiable risks are ones that investors must simply bear the cost of, as they are impossible to do away with unless one does not invest at all.
Examples of such risks are inflation, natural disasters, warfare and any other risks that would affect the performance of the whole industry, not just one stock or business. Diversifiable risk, on the other hand, involves risk that is likely to affect a single asset class or business and affect their performance or potential returns. There are different methods to effectively manage risk, and depending on the likeliness and impact of the risk, different methods are more effective in different situations.
1. Risk avoidance
Whilst most risk management strategies have the objective of managing risks when they occur to reduce the damage, risk avoidance is extreme; one must take every possible action to make sure that risk does not occur; which means essentially not doing anything that could possibly result in that risk. However, many may refer to the adage that the choice to avoid risk is the choice to avoid living and to avoid living is one of the greatest risks of all.
2. Risk mitigation
This is the most commonly practiced strategy of risk management among business owners and investors, and can be described as either decreasing the overall effect of risk, either by reducing the likeliness or the impact of said risk. In the investment space, investors accomplish this by investing in a portfolio with exposure in different asset classes.
This is done so that a risk that would affect a particular asset class does not impact the whole portfolio, and so the weightings of one’s portfolio can be changed according to the perceived likeliness and impacts. Another example would be demanding a premium for riskier pursuits so that an investor is compensated for the higher risk.
3. Risk transference
This strategy involves the shifting of the cost of risk from one party to another through a contractual agreement. A well-known industry thrives on this exact context: the insurance industry has an agreement with the contract-holder, in which they will offset some or all of the cost if the contract-holder is to fall victim to the risk specified in the contract, in exchange for regular payments from the contract-holder to the insurer.
4. Risk exploitation
Different risks are of different nature, some potential occurrences may have a negative effect on a business, whilst another may have positive benefits. Risk exploitation involves the positive benefits: the idea of this strategy is to increase the likeliness that a positive risk should occur, or if the frequency could not be controlled, then manipulation of the risk to maximize the impact of the risk.
There will always be benefits and costs to risk management, but while considering all of those things, especially when making investments, there always has to be a balance between the risk and the reward: One has to understand the kind of return they ideally want to get from any project and decide how much risk they are willing to bear for it. Ideally, the higher the risk, the higher the potential return.