“Not taking risks one doesn’t understand is often the best form of risk management.”
― Raghuram G. Rajan
In the world of finance, risk management refers to the practice of identifying potential risks in
advance, analyzing them and taking precautionary steps to reduce/curb the risk.
When an entity makes an investment decision, it exposes itself to a number of financial risks.
The quantum of such risks depends on the type of financial instrument. These financial risks
might be in the form of high inflation, volatility in capital markets, recession, bankruptcy, etc.
So, in order to minimize and control the exposure of investment to such risks, fund managers
and investors practice risk management. Not giving due importance to risk management while
making investment decisions might wreak havoc on investment in times of financial turmoil in an
economy. Different levels of risk come attached with different categories of asset classes.
For example, a fixed deposit is considered a less risky investment. On the other hand,
investment in equity is considered a risky venture. While practicing risk management, equity
investors and fund managers tend to diversify their portfolio so as to minimize the exposure to
By implementing a risk management plan and considering the various potential risks or events
before they occur, an organization can save money and protect their future. This is because a
robust risk management plan will help a company establish procedures to avoid potential
threats, minimize their impact should they occur and cope with the results. This ability to
understand and control risk enables organizations to be more confident in their business
decisions. Furthermore, strong corporate governance principles that focus specifically on risk
management can help a company reach their goals.
Risk management strategies and processes
All risk management plans follow the same steps that combine to make up the overall risk
• Establish context. Understand the circumstances in which the rest of the process will take
place. The criteria that will be used to evaluate risk should also be established and the
structure of the analysis should be defined.
• Risk identification. The company identifies and defines potential risks that may negatively
influence a specific company process or project.
• Risk analysis. Once specific types of risk are identified, the company then determines the
odds of them occurring, as well as their consequences. The goal of risk analysis is to further
understand each specific instance of risk, and how it could influence the company’s projects
• Risk assessment and evaluation. The risk is then further evaluated after determining the
risk’s overall likelihood of occurrence combined with its overall consequence. The company
can then make decisions on whether the risk is acceptable and whether the company is
willing to take it on based on its risk appetite.
• Risk mitigation. During this step, companies assess their highest-ranked risks and develop a
plan to alleviate them using specific risk controls. These plans include risk mitigation
processes, risk prevention tactics and contingency plans in the event the risk comes to
• Risk monitoring. Part of the mitigation plan includes following up on both the risks and the
overall plan to continuously monitor and track new and existing risks. The overall risk
management process should also be reviewed and updated accordingly.
• Communicate and consult. Internal and external shareholders should be included in
communication and consultation at each appropriate step of the risk management process
and in regards to the process as a whole.
A major lesson in risk management is that a ‘receding sea’ is not a lucky offer of an
extra piece of free beach, but the warning sign of an upcoming tsunami.
The Cost of Risk
In general, the more an active fund and its managers shows themselves able to generate alpha,
the higher the fees they will tend to charge investors for exposure to those higher-alpha
strategies. For a purely passive vehicle like an index fund or an exchange-traded fund (ETF),
you might pay 15 to 20 basis points in annual management fees, while for a high-octane hedge
fund employing complex trading strategies involving high capital commitments and transaction
costs, an investor would need to pay 200 basis points in annual fees, plus give back 20% of the
profits to the manager.
The Bottom Line
Risk is inseparable from return. Every investment involves some degree of risk, which is
considered close to zero or very high for something such as emerging-market equities or real
estate in highly inflationary markets. Risk is quantifiable both in absolute and in relative terms. A
solid understanding of risk in its different forms can help investors to better understand the
opportunities, trade-offs, and costs involved with different investment approaches.
“Current Risk Management tools and techniques in managing Financial Risk fall short of
their ability to manage risk. They work well when market conditions are normal. Thus,
there is a need to develop more appropriate scientific tools for better measurement and
management of financial risk.”
Dr. Mahendra Mehta