Understanding Risk Management

The concept of risk management extends beyond the well-known principle of risk versus reward.  In fact, it extends well beyond the area of financial management and into other parts of life such as security (both physical and digital).  While the topic is fascinating and can be explored in great depth, from the perspective of private individuals, managing the family finances, here are three key principles of risk management which can be applied to any decision.

Only accept risk insofar as it is safe to do so

The idea of accepting only risks which are safe may seem like a contradiction in terms, so it may be easier to explain it in context.  Let’s say a person offers you a bet, that you will flip a coin three times.  Each time it lands on heads, they will pay you £3 and each time it lands on tails, you will pay them £1.  From a purely mathematical perspective, that is an excellent bet and from a practical perspective, your exposure to risk is limited to £3.  Suppose, however, the person suggested increasing the stakes to £300 and £100 or £3000 and £1000.  The maths would still be the same but your exposure to risk would be much greater.  The coin could land tails three times in a row, leaving you out of pocket to the tune of £300 or £3000.  What if the stakes were the whole of your life savings versus one-third of your life savings?  Again, the mathematics is still exactly the same, but would you really be prepared to risk the entirety of your life savings on three coin flips?  Basically, what this principle means in practice is that before you take a financial decision, you should think about what would happen if the worst-case scenario came about and whether or not you could really handle it.

Whenever possible use advance planning to anticipate and hence manage risk

Just as you stop, look and listen before you cross the road, so you should do your own, thorough due diligence before parting with your cash.  Always remember that sales literature, by definition, is designed to sell a product, financial or otherwise, and while the financial services industry is regulated the fact still remains that if people who write sales copy know their job, they will do everything they can to emphasize the attractive features of a product or service and minimize its less attractive features.  For example, they might put the potential rewards in very large text in a very prominent place and the potential risks in the “small print”.  Do your own research thoroughly so you understand what the potential risks are and what, if anything, you can do to mitigate them, or at least their impact on your finances.

Assess risk in a timely manner and with appropriate frequency

The earlier you assess risk, the quicker you can dismiss potential investments which are obviously wrong for your risk profile and hence the less of your time and energy (and possibly money), you will spend investigating products which, ultimately, are not going to be suitable for you.  That said, however, the world is an ever-changing place and the nature and extent of risk changes along with it.  For example, in times gone by, the idea of a bank being robbed would conjure up images of a physical robbery rather than data theft.  Therefore, it is best to make a point of conducting periodic risk assessments to ensure that any products you hold continue to be suitable for you.  Likewise, it’s worth noting that your own risk profile might change and hence you might wish to change your investments to reflect this.