By Liam du Plessis- Chief Executive Officer, Hiraeth Financial
There are not a lot of questions about future events that can be answered with complete certainty. Making predictions on the rate of return against the possibility of being wrong is risk management in a nutshell but only so much is realized before the damage is done.
What is ‘Risk Management’ as an ideology
The notion we underpin around ‘Risk’ is the element of uncertainty, the actual outcome of a given undertaking which might differ from the expected outcome. The term uncertainty implies that there are various outcomes to a given endeavor.
Investors are therefore obsessed with which opportunity offers maximum return with minimum risk but they can really only be set in two categories: the investments with certain outcomes and ones with uncertain outcomes.
As investors may be reluctant to pool money into an uncertain play, they must understand that risky investments offer higher return. This term is coined risk and return.
Managing risk successfully is not merely a static process we undertake but an important part of our decision making whether to avoid a particular route due to stagnant traffic or to go short on a trade you think might dip.
Financial management and the term risk encompasses two important elements which must be considered: Business risk and financial risk.
The uncertainty surrounding companies in the macro-economic environment reflect on the industry as a whole: sales expectation in the event of increased competition, is there substitute products to a given product and the economic downturn known as recession.
An industry has variables which counteract and affect the financial markets directly. Economic indicators such as selling price and expected demand all illustrate an analytic approach to prediction which aid all investment decision makers. With the right information on a given market landscape, investors can rest assured knowing the right people are making the right market moves.
Organizations must put effective measures in place to mitigate risks, the other half involves controlling the existing measures. Many firms have developed a neutral relationship with ‘risk’ and wait until it becomes a necessity then prioritize it in terms of severity with likelihood and consequences not being important variables to bring into the equation.
This leads to ineffective implementation due to rushed processes and an inefficient application of resources which will later bleed the organization of resources, time and have a major effect when you take a glimpse at the books.
Modern technology gives organizations access to enormous amounts of information which can be used to benefit the organization.
An establishment of efficient communication links within an organization can help individuals share information with ease which can save time and money.
Simple links save the organization hassles and improve efficiency, contributing again to the success which will soon follow.
Consequences and likelihood are two variables which help an organization assess their risk appetite whether to play by preservation and hold all assets under management.
Weighing up the effect of a given risk can allow an organization to develop a business continuity plan tailored to their current position and mutual end goal among stakeholders. This will allow organizations to effectively set out a plan or action after they have bared the consequences of a risk.
Likelihood is another variable which allows organizations to weigh up the possibility of a given risk, whether the degree of probability is high or low – depending on how likely the risk is to manifest itself into a problem an organization might face.
Simply put, the organization needs to prepare for the worst but hope for the best.
Financial risk centers around market risk components, namely:
- Interest rate risk
- Equity risk
- Currency risk
Markets are in constant volatility due to fluctuating interest rates, changing stock prices and political instability which causes currency value deviation. Knowing the potential risks which could in turn cause potential losses, is only the first step in the four-point strategy I recommend to effectively manage risk.
- Risk Identification
- Risk Analysis
- Risk Evaluation
- Risk Treatment
The first step in the four-point strategy is risk identification. This involves grouping a team of specialists who have a diverse skill set. They must then identify possible happenings which could deter it from its objectives.
Investment decision makers must look at all possible scenarios in a given investment strategy, taking into consideration – what could happen – how could it happen- and what could these potential risk elements be.
The second step in the four-point strategy is risk analysis. This relates to understanding the risk issue.
Investment decision makers must critically analyze the risk issue. This includes: the causes and source of the identified risk issue, their potential positive and negative consequences and the likelihood of a risk event.
Investment strategies must have a constant risk review method that they follow in every investment decision to carefully monitor and control for it to be useful.
The third step in the four-point strategy is evaluation. Investment decision makers should use a rating scale weighing – likelihood and consequences in terms of severity and degree of importance. This will allow investment decision makers to make calculated attempts to mitigate potential risk issues as they arise and maneuver accordingly.
Once risks are identified and listed,proper analytics can further illuminate e the potential risk issue and then an evaluation process can be put in place to further understand the risk issue. This then moves to the last step in the four-point strategy: Risk treatment.
Investment decision makers can now make the right market moves to treat potential risks. This will allow for better returns, cohesive understanding of similar risk issues and a cooperative workforce.
Investment decision makers can use the four-point strategy in their risk management framework to allow for a more solid methodology for managing the ‘What If’. The medium of instruction is easy to understand and implement.
Risk management as a viable concept can only be correctly applied if the members of the organization see value in it. This carries into another important element of managing risk effectively.
In the effective management of risk, ‘culture’ is the full story. Risk management encompasses a lot more than business operations and include the people who allow it to function. It encompasses a value system among people, a shared belief with real time influence. This allows organizations to make the right moves at the correct time for instant gratification and results.
Once all individuals in an organization understand the value of knowing what could go wrong, they can help bring minds together to help avoid risks which might deter an organization from its objectives.
Risk management is content-based like any other discipline, but it is the role of all within an organization to tailor-make their approach to fit their company’s goals. This is where the real progress is made.
Developing a mandate which everyone can understand and relate to is key for effective risk management within the financial space.