Five Tips To Reduce And Manage Financial Risk
by Ujjal Mondal Finance 08 March 2021
Individuals and businesses face financial uncertainty alike. It can take the shape of deviation from expected earnings, unforeseen losses, or any negative occurrences caused by internal or external vulnerabilities. Businesses use the term ‘risk’ to define these uncertainties.
All investment decisions involve risk. However, the degree of uncertainty or potential losses may vary. Companies and entrepreneurs take investment decisions in expectation of higher returns to compensate for the risk they bear. Humans and businesses both carry a risk-preference. While some entrepreneurs have an appetite for thrill and actively take on riskier investments in search of higher returns, some are risk-averse and carefully manage the risk-reward ratio. Either way, knowing to manage and mitigate financial risk is an essential business skill that every stakeholder should be familiar with to avoid catastrophic financial losses.
With that said, there are several strategies in risk management. The following tips will help business owners and entrepreneurs to understand their risk profile and manage it accordingly:
1.Save to stay afloat
Understanding the difference between income and wealth is key to a successful financial future. When an entrepreneur is in the early stages of establishing the business, her/his general focus is to generate the highest possible income with the least amount of resources.
While a decent income is essential on the path to success, people often offset their income gains with increased expenditure. The point of saving should not be to have a cash balance left in your bank account at the end of the month. Instead, saving should be the first ‘expense’ as soon as an income is generated. This builds the habit of financial discipline early on and creates efficient management of expenses and budgeting systems. Creating adequate cash reserves helps the business to stay afloat in times of economic crunch.
If you wish to educate yourself further on the types of risks and investments available, it would be best to do an online master of accountancy to acquire better insights into the world of finance.
2. Willingly expose yourself to risk
It is essential to understand that regardless of the financial situation, a business or an entrepreneur cannot avoid risk. Every participating member in a capitalist economy is exposed to a certain level of financial stake in the form of inflation. This means that even if one manages to save exorbitant amounts of money, the rising inflation rates (dependent on the country of operations) will continue to devalue the retained wealth.
Instead of being passive to inflationary pressure, it would be besttocontrolyour risk profile and decide the amount of risk you’re is willing to face. To overcome this issue, investing savings into assets is essential. The ROI portfolio should at least match the inflation percentage for the most conservative risk-takers out there. Those who are willing to take more significant risks early should expose their business savings to greater risk levels as higher risk generates higher rewards.
3. Earn to invest
Consumerism in the US has pushed the millennial generation and generation Z into living from paycheck to paycheck. Statistics regarding mean annual household expenditures in the US FY 2019 show that the millennials and Gen Z have saved lesser amounts than their elders. Three causes can explain this phenomenon:
- rising costs of living compared to the percentage change in income levels of all generations,
- increasing amounts of student debts,
- and the quest for instant gratification in the form of an expensive lifestyle.
Earlier generations did well without saving a lot because inflationary pressures were less. In today’s world, the quickest way for entrepreneurs to multiply their wealth is to allow money to work for them. Therefore, the priority should not be to purchase a new car with a bonus. Instead, dividends and other income gains should be utilized to build bigger investment portfolios that can generate enough interest to pay for a new car or other business-related luxuries.
4. Learn the art of diversification
“Never put all your eggs in one basket” is a common phrase uttered in business circles. It means that entrepreneurs should never put all their savings into a single, promising investment opportunity. A better approach is to diversify their portfolio and invest in assets falling into several risk classes. A rule of thumb is to invest one-third of the portfolio in safer assets and distribute the rest of the portions in medium and high-risk investments. This hedges risk against unforeseen circumstances and prevents a total loss in case shit hits the fan!
5. Understand your risk tolerance
An entrepreneur earning a six-figure income at a permanent job will be able to expose herself/himself to riskier investments compared to a retired military veteran who is dependent upon lifetime earnings for survival. Therefore, it is crucial to understand one’s risk tolerance and build an investment portfolio accordingly.
Young individuals can take additional risks early on as they have more potential working years ahead of them to make up for any losses. Middle-aged individuals should strike a balance between high-risk and low-risk investments to sustain their existing wealth while simultaneously growing their portfolio at a steadier rate. Retired individuals should keep a significant chunk of their investments in safer assets to protect their portfolio from the unnecessary risk that could wreak havoc on their savings.
The first step to gain financial freedom is to develop the habit of saving. However, saving without investing is not enough. It makes one lose more real wealth as the savings account rates offered by banks are often lesser than the inflation rate. Educational institutions should divert focus on teaching students personal finance and teach them the importance of early investments for a more secure future. It will also enhance their business acumen once they decide to take up the entrepreneurial route.
Whoever takes part in economic activity exposes themselves to risk. Therefore an active and timely approach to managing risk will compound into financial benefits down the road.