Risk: Manage it now or you will hate yourself later
What is risk?
Risk is around us every day. But what is it?
The Oxford English Dictionary (OED) cites the word appearing in English as risque (from the French) in 1621. The spelling was subsequently changed to the current spelling of risk in 1655.
The OED definition is:
“(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility.”
The Cambridge Dictionary gives a simpler definition of:
“the possibility of something bad happening”.
For those who operate in the financial and investment world the definition can be:
“ the degree of uncertainty about the rate of return on an asset and the potential harm that could arise when financial returns are not what the investor expected.”
All three are similar in the respect that the specter of risk can harm you physically, mentally, and financially.
Defining Your Risk Attitude
Each person and organization is unique. What I determine to be an acceptable level of risk might make someone else squirm. Like the friend who has jumped out of an airplane 30 times, whereas you might not even want to ride in a glass floored elevator.
Different strokes for different folks.
Risk Profile Assessment
The goal of a risk profile assessment is to narrow down how much risk an individual or organization is willing to take when posed with different scenarios. Both from an investment and business decision perspective.
By asking probing questions and recording the answers you are slowly able to identify the level of risk that feels “appropriate” to the subject.
How to Use Risk Questionnaire for Individual(s)
When thinking about these through the lens of an individual the resulting answers ultimately translate into some form of portfolio asset allocation. The hope is to construct a portfolio that will match the individual’s expectations and risk tolerance.
To give you an example of what one of these individual risk questionnaires looks like we are providing you a link to a version from one of our custodian partners (Charles Schwab). You can see it here.
How to Use Risk Questionnaire for an Organization
When dealing with an organization the creation of a risk questionnaire is a slightly more complex situation.
First, you must tackle how people in the organization feel about business decisions and risk. These types of questionnaires cover both narrow and broad topics.
Here are example questions:
- How well are strategic and related objectives defined?
- How are risks monitored and reported in the organization?
- Does the organization include the board when contemplating adjustments that can bring risk?
- Are there any concrete or perceived communication barriers in the organization?
Second, you try to determine the risk profile of the organization around it’s capital and finances.
Here are example questions:
- Do we prefer safety of principal over potential income generation?
- Is there a defined strategy in place for use of idle funds?
- Does the use of derivatives have a clear financial and risk expectation?
- Do our banking partners open the organization to any particular risks?
Risk Vs. Reward
Now that we understand risk and some ways to determine how much risk you can potentially handle. We will highlight simple ways to identify if the risk presented is worth taking for the reward.
For this post let’s focus on 3 different tactics: math, consultation, and gut (aka intuition).
Math is one of the fastest ways you can try to determine if the risk vs reward relationship makes sense. There are whole careers and organizational departments that are constantly crunching numbers to determine risk metrics, risk associations and more.
We want to highlight a couple quick ways simple math can help you determine if a potential opportunity can be quickly removed from analysis.
Please remember these are mental frameworks that may not fit every situation you are considering.
Corporate Finance Ratios
Ratios help investors, analysts, and corporations determine risk and fiscal health.
From an investor standpoint you can use them to determine if a specific company may be a viable investment. Corporations can use them internally to gauge the overall health of the company and to see how specific decisions will change the company risk profile.
Here are a few ratios that are commonly used:
Debt to Equity - this measures a company's leverage from total debt and financial liabilities against total shareholder equity.
Interest Coverage Ratio - this measures a company's ability to pay the interest on its debt obligations. The lower the ratio indicates high levels of debt that may not be able to be paid.
Return on Investment - measures the return of an investment versus the cost of the investment. This can be used on a single investment or on a basket to determine which are the most efficient.
If you want to go down the rabbit hole of ratios you can find formulas and use cases easily on the internet. Here is a link to what we felt was a solid one stop location to learn.
The world is not short on risk management and consultant companies. If you are not inclined to take the task of risk vs reward analysis internally, you can always find a consultant to work with.
These can usually be contracted out for hourly, project by project and retainer contracts. These can offer you specific knowledge and insight you may need without taking on a full time employee.
Gut Check aka Intuition
We have all been faced with a decision and had our internal voice telling us what to do. Many times what we felt was the right decision ultimately panned out in our favor. We call this gut check and it can potentially save you lots of time when deciding on a risk versus reward situation.
Please do not misunderstand that using your gut check feeling alone is your solution. Depending on the data that is available to you, the gut check may only serve as the confirmation trigger to the decision.
Professor Laura Huang of Harvard Business School wrote a brief post articulating when the gut tends to work best. You can read it here.
Ways to Track & Manage Risk
Now that we have knowledge about risk, how you feel about it, and the trade offs. We will discuss how to track and manage it.
One of the most common ways to manage and track risk is by standard deviation.
Statistically standard deviation is a measure of how much an investment's returns can vary from the average return. It is essentially a measure of volatility and therefore risk.
Calculating the standard deviation of an investment (or portfolio) shows historically how volatile things have moved. The higher the standard deviation number, the more volatile and potentially risky it is.
For example, if an investment has a high standard deviation you should expect wide and potentially erratic price swings.
When risk managers use standard deviation as a tool you will often hear them speak about how many standard deviations it is from the mean (average). i.e. one standard deviation, two, etc.
Statisticians expect to find 68% of measurements within one standard deviation of the mean. 95% of all measurements generally fall within two standard deviations. As the measurements continue higher and reach three standard deviations one can assume something serious is happening and adjustments might need to be made.
Here is an example of how this can be used in a business setting away from investments.
If your monthly sales have slumped to the tune of one standard deviation of the average it should not make you sweat. This is normal and just could indicate an off month. If it reaches two standard deviations you might be looking at trouble and need to watch closely. A reading of three deviations and something major might have changed. You should investigate deeply and try to isolate what has made this impact.
You can quench your thirst for knowledge about standard deviation from this wiki.
Life, business, and investing is constantly a balance between risk and reward. Every decision you make can ultimately be attributed to success or failure. The key is understanding risk and not fearing it.
If you learn to frame risk versus reward properly for yourself and your organization you are on the right path. If you then go to the next level and try to track and manage it you are going farther than most.
We hope that this post plants the seeds of how you can think and act upon the risks you face. Don’t hesitate to contact us with any thoughts, questions or comments!
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