Risk Management

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What is 'Risk Management'

Risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs any time an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given his investment objectives and risk tolerance.

BREAKING DOWN 'Risk Management'

Inadequate risk management can result in severe consequences for companies as well as individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.

Risk management occurs everywhere in the financial world. It occurs when an investor buys low-risk government bonds over more risky corporate debt, when a fund manager hedges his currency exposure with currency derivatives and when a bank performs a credit check on an individual before issuing a personal line of credit.

How Do Investors Measure Risk?

Investors use a variety of tactics to ascertain risk. In some cases, they look at the average return of an investment, and they find its average standard deviation over the same time period. Then, they apply a bell curve to that number, which dictates that the expected return of the investment is likely to be one standard deviation from the average two-thirds of the time and two standard deviations from the average deviation 95% of the time. This helps investors evaluate risk numerically. If they believe that they can tolerate the risk, financially and emotionally, they invest.

For example, imagine an investment has an average return of 7% over a 20-year period. During that same time, the average standard deviation is 13.5%. This is the difference between the average and the real price at most given points throughout the 20-year period. The investor can assume, with relative certainty, that 67% of the time, the investment is going to increase or decrease by the standard deviation of 13.5%, and he may also assume a 27% increase or decrease 95% of the time. If he can afford the loss, he invests, but he also has to be aware of the 5% of the time when outliers occur.

What Is Enterprise Risk Management?

Enterprise risk management (ERM) encompasses all kinds of risks throughout an organization, and it creates plans for managing that risk. Industries such as aviation, construction, public health, international development, banking, finance and insurance utilize ERM. People who work with ERM focus on assessing the risks relevant to their companies or industries, prioritizing those risks, and making informed decisions to mitigate them.

What Are Risk Management Plans?

Project managers create risk management plans to estimate the impact of various risks and outline possible responses if a certain risk materializes. For example, the Environmental Protection Agency (EPA) requires facilities that deal with extremely hazardous substances to develop risk management plans to address what they are doing to mitigate risks and what they will do if an accident occurs.