There is inherent risk in everything that we do. Some choices we make create higher risk than others, but part of life is that we can’t predict exactly what will happen. This same principle can be applied to the world of business and investing.
No matter how carefully you invest your money there will always be risk involved, because no one can predict exact market changes. It is our ability to manage risk that will give us greater peace of mind, and hopefully greater financial returns.
Whether you are aware of it or not, all investors manage risk. At the core, investing is about placing resources and capital into selected risks. The hope is that these risks will pay off and you will be rewarded with growth, but you can’t just leave it up to destiny.
This is where risk management comes in. Managing risk allows investors and companies to actively align their goals with their investment choices. Good risk management will result in more desired outcomes.
Finance executive Lucas Birdsall currently works as a Venture Capitalist with Parabellum Investment Strategies Ltd., a Vancouver based merchant banking firm. In his role Birdsall focuses on the management of investments across natural resources, pharmaceuticals, and technologies. “A large part of my role is completing risk assessments to optimize our outcomes,” shares Birdsall. By choosing what risks his firm takes, he helps steer them to higher profit and share prices. But how does one make risk management decisions?
“There are many different measures you can use when it comes to analyzing risk,” explains Lucas Birdsall. Standard deviation is commonly used to gauge the volatility of an investment, using its historical performance relative to its rate of return. This determines the risk level of a particular stock. “This particular tool allows us to rank potential investments in order of their associated risk”.
Using historical data, the Sharpe Ratio allows investors to see how much extra return they are getting in relation to the extra volatility of their investment. A higher Sharpe ratio means a better risk adjusted performance. “While it is great to measure a stock’s historical performance, it is also important to compare it against the market as a whole,” says Birdsall. “We measure a sector’s systemic risk against the entire stock market”.
But how effective is risk management? Investment firms place a large emphasis on it, because poor performance can result in severe consequences for the economy, companies and individuals. A prime example of poor risk management that led to disaster is the mortgage meltdown that led to the financial crisis of 2008. Banks and lenders handed out mortgages to people regardless of their credit or income. This resulted in a rise of mortgage-backed securities which was profitable until the rising default rates resulted in a disastrous loss in revenue. Since then, best practices in risk assessment have been re-evaluated and more stringent standards have been put in place.
“When it comes down to it, putting in the effort to understand the market and your investments can save you a lot of heartache later down the line,” shares Birdsall. Risk management methods are standard practice in the world of business and investments, but they can also be translated for personal finance. Start by identifying your goals and the risks associated with them. Then you can choose what investments and financial decisions are most likely to help you meet those goals.
Risk is an inevitable part of the financial world. Although the word may have a negative connotation, without risk we wouldn’t have the potential for high returns. It is our knowledge of risk management that allows us to help mitigate losses and instead be rewarded in return.
