Risk Management

What is risk?

Risk encompasses all of the uncertain environmental variables that lead unpredictability of outcomes.

Taking risk is an integral part of conducting business and managing investment portfolios.

What is Risk Management?

While risk is generally seen in an unfavourable light, the challenge lies in carefully choosing, understanding and managing the risks entailed by your decisions.

• Risk management is not about minimising risk - It is about actively understanding and embracing those risks that offer the best chance of achieving organization's goals with an acceptable chance of failure.
• Risk management is not even about predicting risks - It is about being prepared for (positive or negative) unpredictable events such that their impact would have already been quantified and considered in advance.

Interaction between Risks

It is very important for organisations to recognise that risks interact, and that the interaction is more "toxic" in stressed market situations.

When different sources of risk come together, the combined risk is almost always non-linear in that the total risk faced is much greater than the simple sum of the individual risks, and this makes the situation even worse.

Most risk models and systems do not directly account for risk interactions.

Risk Management

Risk refers to the likelihood that your assets will decrease in value.

Risk is unique in that it applies to the probability of losses occurring, and the potential value of those losses.

In finance, risk is considered a type of cost.

All decisions you make have some degree of inherent risk.

Inaction too often has the greatest amount of risk, so rather than becoming paralysed by attempting to avoid all risk, look at it as a type of cost that allows you to calculate whether a financial decision will reap greater benefits that the potential losses and to compare the available options.

There are a variety of different ways to:

• avoid risk,
• reduce risk, or 
• even share risk.

Each of the above has a price.

By calculating the cost-value of specific risks, it becomes possible to determine whether any of the tools available for managing risk are financially viable and are themselves an appropriate risk.

Risk management is a critical part of financial success.

You should explore:

• the different types of financial risk, 
• the ways in which risk is measured and 
• how to effectively manage the amount of risk to which you are exposed.

Additional notes

Ways to avoid risk:  diversification and appropriate use of derivatives

Ways to share risk:  insurance

In the end, the best tool you have available to you in limiting the costs associated with risk is simple due diligence.

• Do your research, make decisions which make sense to you and keep watching so you know when that decision doesn't make sense anymore.
• If someone's credibility is in question, risk mitigation can come in forms as simple as asking for a nonrefundable down-payment, just as banks will sometimes ask for collateral before issuing loans.
• Preparing for losses can be as simple as keeping enough funds available in a liquid form so you can pay your bills until you regain your losses.  
• The duration of your exposure to losses can be shortened by ensuring you always have an exit strategy - before you commit to a decision, develop a way to undo it in a worst-case scenario.

Like most things, you get out of risk management that you put into it, and as the amount of potential risk increases, so should your intolerance for sloppy risk management.

Sun Tzu & The Art of War - Applied to Portfolio & Risk Management

It would be helpful for you to have these two texts, especially Clavell's, to reference as you read through these comments.

Once you get past the first section of these comments, Application of Selected Sun Tzu Phrases To Portfolio Management and Risk Management, the following sections are organized to follow the chapter titles in Clavell's book; with Griffith's chapter titles in parentheses, and quotes treated as supplemental information.

Within each chapter section, before each Clavell quote or series of quotes, I have inserted a brief heading label that characterizes the substance of the quote(s) and the companion portfolio management and risk management corollaries.

	• Selected Phrases - Application of Selected Sun Tzu Phrases To                                     Portfolio Management and Risk Management
	• Chapter I - Laying Plans (Estimates)
	• Chapter II - On Waging War (Waging War)
	• Chapter III - The Sheathed Sword (Offensive Strategy)
	• Chapter IV - Tactics (Dispositions)
	• Chapter V - Energy (Energy)
	• Chapter VI - Weak Points & Strong (Weaknesses and Strengths)
	• Chapter VII - Maneuvering (Maneuvre)
	• Chapter VIII - Variation Of Tactics (The Nine Variables)
	• Chapter IX - The Army On The March (Marches)
	• Chapter X - Terrain (Terrain)
	• Chapter XI - The Nine Situations (The Nine Varieties of Ground)
	• Chapter XII - Attack By Fire (Attack by Fire)
	• Chapter XIII - The Use Of Spies (Employment of Secret Agents)
	• Summary - Summary of The Art Of War as applied to Portfolio and Risk Management.

http://www.strategies-tactics.com/suntzu.htm

Buffett: The Buck Stops Here

On Risk Management

A CEO must not delegate risk control.  It's simply too important.  At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries.   ...If Berkshire ever gets in trouble, it will be my fault.  It will not be because of misjudgements made by a Risk Committee or Chief Risk Officer.

When things go wrong: Lessons for risk management

The responses to risk will vary from business to business and from risk to risk, but they tend to fall into one of these categories:

• eliminating risks
• tolerating risks
• minmising risks
• diversifying risks
• concentrating risks
• hedging risks
• transferring risks
• insuring risks.

Deciding which of these responses is appropriate in any given situation requires careful analysis of the risk in terms of probability, impact and potential outcomes.


If the downside result of a specific, foreseen risk occurs, you will want to look at the way you analysed it and chose your response, and the effectiveness of the chosen response.  Consider questions such as: 


1.  Are there any clear lessons for your estimates of probability?  (For example, has an event that was regarded as extremely rare happened twice in a week?)


2.  How accurate was your assessment of impact?

• Was it more or less severe than anticipated?
• Did it affect areas you didn't predict?
• Did it have consequences of a different nature than those you expected?

3.  Were the plans and processes made to deal with operational risks effective in practice?

• Should they be improved?
• What alternatives are there?

4.  Could operational problems occur again?

• Is the situation different now?
• If not, how should it be changed?

5.  Did you choose the right response to the risk?

• How has it worked out in practice?
• Do you need to choose a different response in future, or just make the chosen response work better?

6.  If you chose to tolerate a risk, was this the right decision?

• Was it based on enough probability and impact information, or information of sufficient reliability?

7.  If you chose to try and minimise a risk, what effect did this have on its impact?


8.  Can you demonstrate the link between your decisions and the positive results for the business?


9.  If you chose to hedge against a risk, how good was the hedge?  How balanced were the different risks against each other?


10.  If you chose to diversify risks, was the extra effort worthwhile?


11.  If you chose to concentrate risks, was the saving in effort worth the extra exposure incurred?


12.  If a risk was transferred, did the third party accept responsibility when things went wrong?


13.  What knock-on effects are now apparent?

• Is the outcome fully known (or knowable), or is it still unfolding?
• What new risks have arisen?
• What new decisions now need to be taken?