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.
These principles originate from the discipline of project
management, which focuses on planning and careful observation to accomplish
goals in the most efficient and effective way possible. 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 – from the
trivial (an employee loses R100 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 highly probable but essentially harmless,
while others could be devastating but are 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.
* Anna Malczyk is the Academic Officer at GetSmarter, an
online education facility that features the University of Cape Town's Project
Administration short course.