You might be familiar with the concept of risk and how it works, but do you know how to apply strategies for managing it?
Risk is an inescapable part of investing, and if you have the knowledge, you can take action to minimize its impact. This ability to minimize risk can result in significant and consistent growth for your portfolio.
There are several strategies for managing risk, including avoiding it, reducing its impact, and transferring the risk to someone else. Businesses, individuals, and investors alike need to consider these options when determining their approach to dealing with risk.
This article answers risk management questions including:
- What are the five proven options you have for managing risk?
- What is the most common form of risk sharing that we all participate in?
- What is a drawback of choosing to avoid all risks?
- What is one potential disadvantage of risk retention?
- How can a financial advisor in Bountiful, UT help you manage risk?
Risk is an inherent factor in any investment decision. If you need help sorting through the details and choosing the optimal strategy, feel free to connect with our professionals at ARS. We’ll provide a risk assessment and help make your financial goals a reality.
1. Avoiding Risk: Taking Effective Proactive Measures
Avoiding risk is the most effective way to reduce your overall risk profile and protect yourself from potential losses. It’s also the most common form of risk management.
To avoid risks, you may choose to do business only with suppliers that are known for their ethical practices or avoid certain types of investments.
In general, doing your research and not getting involved in high-risk investments is a fundamental strategy for avoiding unnecessary risks.
Avoiding risk isn’t a perfect solution.
While avoiding excessive risk is crucial, avoiding risk altogether isn’t likely to get you anywhere in terms of your investments. Avoiding all risk may mean maximum security, but it also means that your portfolio’s growth may be severely hindered and won’t grow to its peak potential.
By having a thorough idea of how much risk you can handle, you can find a critical balance between a worthwhile rate of return and accepting a reasonable amount of risk.
2. Risk Retention: A Versatile Strategy Where You Accept Risk
Retention is the practice of retaining risk rather than transferring it. This decision is often accompanied by actions to reduce the impact of the risk. Those who choose to retain risks are responsible for monitoring and mitigating as necessary.
Retention is a common approach to risk management because it can be used for all types of risks—except those that are transferable or not suitable for transfer. One such example of a non-transferrable risk is credit card fraud.
Potential drawbacks of risk retention.
Since the decision to retain risk is made by a manager or investor, there’s potential for human error within that process. Bad investments happen all the time, and they often start with an over-zealous investor deciding to take on excessive risk.
By underestimating the risk you’re retaining, you stand the chance of taking on far more than you’re prepared to handle. Meaning, if the worst happens, the chance of taking losses is higher than you initially planned for.
On the contrary, overestimating the risk can result in slow advancement and potentially poor gains. It’s critical to remember that a greater amount of risk typically leads to a higher pay out, so taking on too little risk will lead to marginal, and often disappointing, returns on investment.
3. Sharing Risk: Taking a Fraction of the Risk for a Partial Payoff
Risk sharing is a form of risk management in which two or more parties share the cost of an event. Sharing risk can be done on a macro level by companies, governments, or other organizations, or on a micro level by individuals.
Organizations that share risks include insurance companies and reinsurance companies.
Individuals may share risks when they enter into agreements with others to offset possible losses from certain events—they essentially make bets against each other about future happenings.
The most common example of risk sharing: Insurance
One example of risk sharing that we all participate in is purchasing insurance. An insurance policy involves outsourcing risk to the company. For sharing their part of the risk, an insurance company charges a fee or monthly premium.
Pitfalls to be aware of regarding risk sharing.
While sharing risk carries the obvious benefit of not losing as much if a catastrophic event takes place or a deal falls through, it also means a fraction of the gains you normally would have earned. Not to mention, there’s potential for costs to outweigh the gains any party will receive.
Another concern is the trust requirement involved with risk sharing. If a business partner or insurance company tries to find a loophole to get out or doesn’t honor their part of the deal, it could lead to major losses for the responsible party.
4. Transferring the Risk: Pay More for Someone to Take the Risk
When avoiding risk isn’t a viable option, another way to manage risk is by transferring it to another party. When you transfer a risk, you’re shifting the burden of dealing with that risk elsewhere. Typically, you’re paying for someone else to assume the risk.
Common examples of transferring risk
- Insurance: You buy insurance for your car and home for instance, so if those things get damaged or stolen in an accident or fire, the insurance company will cover the costs of repairs or replacement instead of you having to pay for everything out of pocket.
- Contractual Guarantee: If someone does not perform their services as promised under contract terms, then they may be held responsible for damages sustained by third parties due to failing to fulfill their end of the bargain.
- Transferring Risk of Theft to a Security Company: For many types of businesses, theft is a major concern, so they’re willing to pay to transfer that risk. Retail companies, tech stores, and many others regularly succumb to theft, making transferring that risk a viable choice.
- Subcontractors Completing Jobs for General Contractors: General contractors sign a legal document guaranteeing their responsibility for completing a job. They may hire a subcontractor to handle some aspect of the job, thereby paying to transfer some degree of the risk.
There are potential problems with risk transfer.
The primary source of issues regarding risk transference is based around human error. One example of this possible error is the misjudging the risk. If risk is not properly assessed, you could end up paying to mitigate a risk that isn’t a real concern, ultimately resulting in wasted fees and a sunk cost.
5. Loss Prevention and Reduction: Reducing the Risk and Impact
Loss prevention and reduction is a way of managing risk by taking steps to reduce the chances of a loss occurring. It’s an approach that you may want to take when there is no way for you to completely avoid or transfer the risk.
For example, if you wanted to protect yourself from getting into an accident in your car, but still drive on roads with other cars and trucks, then loss prevention and reduction would be the best strategy for your situation.
In this case, it could mean investing in safety features like airbags or seat belts that will help ensure your survival after an accident occurs.
On the other hand, if there are things that can be done—like buying insurance policies—to avoid accidents altogether, then avoiding these things would be preferable over trying to reduce them after they happen.
Ultimately, avoiding, sharing, or transferring risk is optimal, but when you can’t, it’s crucial to take steps to minimize the impact.
ARS Can Guide You through the Risk Management Process
“Don’t be fearful of risks. Understand them and manage and minimize them to an acceptable level.” – Naved Abdali
Indeed, choosing to invest, start a business, and almost every other decision involves a degree of risk. Those who learn to control, manage, and mitigate risk stand the best chance of success.
At ARS, our advisors know the types of risk management that will work for your investment, income, and insurance decisions. With decades of experience and a proven process, you can count on our professionals to ensure you’re making the right moves with your money. Connect with us today for a free portfolio analysis.
Ready to apply risk management strategies to your retirement planning? Simply click our eBook below to download it for free. It will provide proven solutions to your retirement planning questions.
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