While investing money, lack of risk management becomes a matter of concern as no one wants any unexpected risk to their money. A survey report found that around 30 percent of people hesitate to invest money.
Fourteen percent of people are afraid of losing their money, 11 percent think the investment process is very cumbersome, and the remaining 5 percent believe it’s a trap. Overall, this fear is the result of the absence of risk management.
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What is risk management in finance?
In simple terms, risk management is a legitimate process of identifying, analyzing, and mitigating any kind of uncertainty in decisions regarding investment.
Although risk is unavoidable when someone wants a handsome return, one can still reduce it. Strategies of risk management include sharing, retention, transferring, avoidance, reduction, and prevention of loss.
In general, there are four types of risk management in finance: risk transference, risk acceptance, risk avoidance, and risk mitigation. In terms of finance, risk management also includes evaluating a company’s current possible financial risks and managing them. Doing so reduces the exposure of that company to any kind of financial mishap.
How does risk management in finance work?
Risk is often quantified in relative terms. A good idea about risk in all its different forms can help investors keenly understand the trade-offs, opportunities, and expenditures involved with various approaches towards investment.
After identifying a certain risk through the risk management process, one needs to know how to deal with it to still make profit. For example, one can surely go for U. S. Treasury bonds instead of corporate bonds. Another example is when a money manager does things like portfolio diversification, asset allocation, and position sizing to reduce or manage financial risks.
Meeting the financial goals by reducing the probability of losses is possible through diligent risk management. There are a few techniques that will help us understand how risk management actually works and benefits us.
- Avoidance: The most conventional way to reduce risk is to avoid it completely by not attempting to invest in any kind of volatile plan. One can opt for the safest assets and have no risks at all. However, the return on these assets are generally not very grand;
- Retention: This is kind of a self-awareness technique where your mind accepts that with the financial territory, risk shall come one’s way;
- Sharing: This is a good technique where two or more parties agree to share a particular risk. Doing so helps them in bearing lower risk as the portion of uncertainty is now divided among all;
- Transferring: One’s risks can be transferred from him/her to someone else. For example, if the premiums are up to date, then health insurance’s risk coverage can be passed from one person to his/her insurer;
- Loss prevention and reduction: This technique asks us to focus on minimizing the loss rather than trying to annihilate the possibility of it. Diversification is a decent example of reducing losses that the investors generally do.
Importance of risk management in finance
Risk management is very important in finance because investments are highly dependent upon it. The investors rely upon it for better returns. Risk management tools help individuals or companies meet their goals without suffering heavy losses. The stability of the share market also depends heavily on risk mitigation.
Risk management also assures an investor that the risk is well-calculated and the market’s arrow will behave just accordingly. In a nutshell, it ensures stability and profit.
Read more: The herd effect in finance: what it is and how it works
