2 Types of Risk Pros Use One, Novices the Other

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The Importance Of Diversification

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Key Takeaways

  • Diversification reduces risk by investing in investments that span different financial instruments, industries, and other categories.
  • Risk can be both undiversifiable or systemic, and diversifiable or unsystemic.
  • Investors may find balancing a diversified portfolio complicated and expensive, and it may come with lower rewards because the risk is mitigated.

Different Types of Risk

Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification—it is just a risk investors must accept.

Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry.

The second type of risk is diversifiable. This risk is also known as unsystematic risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

Why You Should Diversify

Let’s say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks will drop. That means your portfolio will experience a noticeable drop in value.

If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.

But, you could diversify even further because there are many risks that affect both rail and air because each is involved in transportation. An event that reduces any form of travel hurts both types of companies. Statisticians, for example, would say that rail and air stocks have a strong correlation.

By diversifying, you’re making sure you don’t put all your eggs in one basket.

Therefore, you would want to diversify across the board, not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.

It’s also important to diversify among different asset classes. Different assets such as bonds and stocks will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio’s sensitivity to market swings. Generally, bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.

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And finally, don’t forget location, location, location. Diversification also means you should look for investment opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.

Problems with Diversification

While there are many benefits to diversification, there may be some downsides as well. It may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments. Secondly, it can put a dent in your bottom line. Not all investment vehicles cost the same, so buying and selling may be expensive—from transaction fees to brokerage charges. And since higher risk comes with higher rewards, you may end up limiting what you come out with.

There are also additional types of diversification, and many synthetic investment products have been created to accommodate investors’ risk tolerance levels. However, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify against the stock market.

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee it won’t be a losing investment. Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

How Many Stocks You Should Have

Obviously, owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. There is a debate over how many stocks are needed to reduce risk while maintaining a high return.

The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

The Bottom Line

Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely.

You can reduce the risk associated with individual stocks, but general market risks affect nearly every stock and so it is also important to diversify among different asset classes. The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night’s rest.

Business Risk

Business Risk Definition

Business risk is the risk associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.

Business risk can be influenced by multi-faceted factors. For example, if a firm isn’t able to produce the units to make profits, then there is a huge business risk. Even if the fixed expenses are usually given before, there are costs that a business can’t avoid – e.g. electricity charges, rent, overhead costs, labor charges, etc.

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Types of business risk

Since business risk can happen in multi-faceted ways, there are many types of business risks. Let’s have a look at them one by one –

#1 – Strategic risk:

This is the first type of business risk. The strategy is a major part of every business. And if the top management isn’t able to decide the right strategy, there’s always a chance to fall back. For example, when a company introduces a new product to the market, the existing customers of the previous product may not accept it. The top management needs to understand that this is an issue of wrong targeting. The business needs to know which customer segment to aim at before it introduces new products. If a new product doesn’t sell well, there’s always a greater business risk of running out of business.

#2 – Operational risk:

Operational risk is the second important type of business risk. But it has nothing to do with external circumstances; rather it’s all about internal failures. For example, if a business process fails or machinery stops working, the business won’t be able to produce any goods/products. As a result, the business won’t be able to sell the products and make money. While strategic risk is pretty difficult to solve, operational risk can be solved by replacing the machinery or by providing the right resources to start off the business process.

#3 – Reputational risk:

This is also a critical type of business risk. If a company loses its goodwill in the market, there is a huge chance that it would lose its customer base as well. For example, if a car company is blamed for launching cars without proper safety features, it would be a reputational risk for the company. The best option, in that case, is to take back all the cars and return each one after installing the safety features. The more accepting the company would be in this case, the more it would be able to save its reputation.

#4 – Compliance risk:

This is another type of business risk. To be able to run a business, a business needs to follow certain guidelines or legislation. If a business is unable to follow such norms or regulations, it is difficult for a business to exist for long. It’s best to check the legal and environmental practices first before forming a business entity. Otherwise, later on, the business will face unprecedented challenges and unnecessary law-suits.

How to measure business risk?

Business risk can be measured by using ratios that fit the situation a business is in. For example, we can see the contribution margin to find out how much sales we need to increase to be able to increase the profit.

But it differs as per the situation and not all situations will suit similar ratios. For example, if we want to know the strategic risk, we need to look at the demand vs. supply ratio of a new product. If the demand is much lesser than supply, there’s something wrong with the strategy and vice versa.

How to reduce business risk?

  • First, the business should reduce costs as much as possible. There are costs that are unnecessary for businesses. For example, instead of hiring full-time employees if they hire employees on a contract, a huge cost would be reduced. Another example of cost reduction might be using the shift formula. If the business works 24*7, and the employees work on shifts, the production every month would be huge, but the cost of rent would be similar.
  • Second, the business should construct its capital structure in such a way that it doesn’t need to pay a hefty sum of money every month to pay off the debt. If a business assumes that its business risk is going through the roof, it should be trying to create a capital structure through equity financing only.

This has been a guide to what is Business Risk. Here we discuss the four types of business risk, measurement of business risk and how to reduce the same. You may also learn more about Corporate Finance from the following recommended articles –

1. Risk Management: Identifying Risks

Термины в модуле (35)

a. Discuss features of the risk management process, risk governance, risk reduction, and an enterprise risk management system

This definition highlights that risk management should be a PROCESS, NOT JUST AN ACTIVITY

1. Defines its risk tolerance, which is the level of risk it is willing and able to bear.

2. Identifies the risks, drawing on all sources of information

3. Measure these risks using information or data related to all of its identified exposures

*Risk measurement more often than not it involves expertise in the practice of modeling and sometimes requires complex analysis

The execution of risk management transactions is itself a distinct process; for portfolios, this step consists of trade identification, pricing, and execution

2. Then we select the appropriate pricing model and enter our desired inputs to derive our most accurate estimate of the instrument’s model value.

3. Look to the marketplace for an indication of where we can actually execute the transaction.

If the execution price is “attractive” (i.e., the market will buy the instrument from us at a price at or above, or sell it to us at a price at or below, the value indicated by our model), it fits our criteria for acceptance;

If not, we should seek an alternative transaction.

In areas in which they do have an edge, they tend to hedge only tactically.

They hedge when they think they have sufficient information to suggest that a lower risk position is appropriate.

They manage risk, increasing it when they perceive a competitive advantage and decreasing it when they perceive a competitive disadvantage (they EFFICIENTLY ALLOCATE RISK)

RM involves far more than RISK REDUCTION or HEDGING (one particular risk-reduction method)

Understanding the 4 Types of Risks Involved in Project Management

by Balaji Viswanathan · Published October 3, 2020 · Updated February 8, 2020

Introduction

Complex projects are always fraught with a variety of risks ranging from scope risk to cost overruns. One of the main duties of a project manager is to manage these risks and prevent them from ruining the project. In this post, I will cover the major risks involved in a typical project.

1. Scope Risk

This risk includes changes in scope caused by the following factors:

  • Scope creep – the project grows in complexity as clients add to the requirements and developers start gold plating.
  • Integration issues
  • Hardware & Software defects
  • Change in dependencies

2. Scheduling Risk

There are a number of reasons why the project might not proceed in the way you scheduled. These include unexpected delays at an external vendor, natural factors, errors in estimation and delays in acquisition of parts. For instance, the test team cannot begin the work until the developers finish their milestone deliverables and a delay in those can cause cascading delays.

To reduce scheduling risks use tools such as a Work Breakdown Structure (WBS) and RACI matrix (Responsibilities, Accountabilities, Consulting and Information) and Gantt charts to help you in scheduling.

3. Resource Risk

This risk mainly arises from outsourcing and personnel related issues. A big project might involve dozens or even hundreds of employees and it is essential to manage the attrition issues and leaving of key personnel. Bringing in a new worker at a later stage in the project can significantly slow down the project.

Apart from attrition, there is a skill related risk too. For instance, if the project requires a lot of website front end work and your team doesn’t have a designer skilled in HTML/CSS, you could face unexpected delays there.

Another source of the risk includes lack of availability of funds. This could happen if you are relying on an external source of funding (such as a client who pays per milestone) and the client suddenly faces a cash crunch.

4. Technology Risk

This risk includes delays arising out of software & hardware defects or the failure of an underlying service or a platform. For instance, halfway through the project you might realize the cloud service provider you are using doesn’t satisfy your performance benchmarks. Apart from this, there could be issues in the platform used to build your software or a software update of a critical tool that no longer supports some of your functions.

Using a Project Management Tool to Help Mitigate Risk?

Many of the risks mentioned above could be minimized or eliminated by implementing robust project management tracking and communication through the many online tools now available. Take at look at a two mentioned below to see if one could fit in your reality:

Conclusion

If you want to go deeper into this subject, you could consider buying the book that is suggested for PMI preparation – Identifying and Managing Project Risk: Essential Tools for Failure-Proofing Your Project.

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