There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
“Risk management” has become a term used quite often in the business world today. In fact, most companies now have dedicated risk management departments to oversee their day to day business transactions and to come up with strategies. So what is all the buzz surrounding “Risk management”?
Every business faces risks that could present threats to its success.
In order to understand risk management and its importance, we first need to define what risk is. In laymen terms, a risk is the uncertain outcome of an event, whether positive or negative. In business terms, however, we expand on that definition. A risk is defined as an uncertain event that may affect the objectives of the company. Now, if the event is expected to have a negative effect, it is said to be a “threat”. However, if the positives are expected to outweigh the negatives, the risk is defined as an “opportunity”. The total effect on the company’s objectives is known as risk exposure.
Risk management involves examining potential risks and factoring them in a company’s decision-making process, along with minimizing the threats and maximizing the opportunities from that particular risk. It is vital for a company to identify all possible risks in order to make a profitable decision. To understand risk management better, let us take the example of a company planning to invest in a new franchise building in a particular location. The risk management process can be divided into three major steps.
The first step to the process would be to identify all the possible risks involved in investing in that particular location. Supposing if the franchise is to be based in a remote area, the risks involved would include social, economic, and infrastructural risks.
There is the social risk of the locals objecting to the construction of a new building. There’s also the economic risk of the franchise not generating enough revenue to surpass the breakeven point and going into loss. Along with that, there’s also the infrastructural risk of the landscape not being able to meet the demands of the new building.
The second step involves assessing the impacts that the particular risk will have on the objectives of the company. In the example above, this would include assessing how the public image of the company will suffer if the construction goes through, along with the CO2 levels emitted into the atmosphere due to the operations of the company and the profit that can be made, along with the costs of running and operating.
The final step is to take the appropriate actions and decisions to reduce the threat and increase the opportunity impact. This can include changes in management, offering incentives to the locals in order to garner a better public image, or using environmentally friendly construction procedures to lessen the environmental impact.
The Importance of Risk Management Strategies
As you can see from the above example, devising a risk management strategy can help an organization or firm make the best possible decisions. An effective risk management strategy can allow an organization to work at optimum capacity, utilizing all its resources properly. Along with that, risk management allows companies to be prepared for any sort of shortcomings they might face in their day to day decision-making process.
Examples of Risk Management Strategies
Most companies would take a risk based on two major factors; if the benefits from the opportunity outweigh the disadvantages from the threat, and if the probability of a threat is low. There are certain risk management strategies that investors also use to minimize the probability of a loss, such as diversification.
Diversification means investing capital in a variety of smaller assets instead of a big one. This allows for several benefits while reducing risks. For one, the loss from a smaller failed investment would be relatively low as compared to losing all capital in a larger failed investment. Secondly, the risk of a bad investment is relatively low through diversification. Let’s have a look at an example.
Let’s suppose you invested all your capital in a Japanese automobile company back in 2011. Due to the tragic floods that hit Japan in 2011, production and export of many Japanese goods were halted, including the company you invested in. You go into loss and all your money is lost.
If you had diversified and invested in a variety of sectors, the loss you would have suffered would be outweighed by your other good investments. Yes, you would still be suffering a loss from the investment, but it would be on a much smaller scale as compared to non-diversifying your investment.
Don’t put all your eggs in one basket.
This is why an effective risk management strategy such as diversification is so important. However, different companies face different risks, so there is no general risk management strategy that can be used by everyone.