Every business decision involves an element of risk. Management’s job is to assess that level of risk as best as possible, and to weigh that risk correctly against the potential rewards.
That risk-versus-reward equation is the basis for taking calculated risks, often referred to as your “risk-adjusted return on investment.”
So how should an executive team approach this process?
Why Risk Management Is Important for Businesses
Risk management is crucial for a business because it gives the management team the tools to identify and handle potential risks effectively. Once a risk is recognized, executives have an easier time reducing its potential harm. Moreover, risk management provides a foundation for making sound decisions.
For any business, evaluating and managing risks is the best way to be prepared for challenges that could hinder progress and growth. By carefully considering how to handle potential threats and creating strategies to address them, businesses improve their chances of succeeding.
Furthermore, a strong risk management strategy can address the most critical risks promptly and decisively. This approach equips management with the necessary information to make informed decisions and assures that the business remains profitable.
How Much Risk Is Too Much?
To answer this, you need to understand your risk appetite. That involves asking several other questions, such as:
- How much risk does your business face?
- How much risk can your business handle?
- How much risk should your business take?
- How much risk does your business want to take?
- How much risk will your business end up taking?
- How much risk is your business currently taking?
There’s no straightforward answer to how much risk is “too much” for your business. It’s a decision that requires careful consideration, considering your personal risk tolerance, your business objectives, and the potential consequences of taking on excessive risk. For example:
- Personal risk tolerance: assess whether you are comfortable with higher risk levels or prefer a more cautious approach.
- Business goals: determine what you want to achieve with your business. If your goal is to make some extra money, but nothing more, you can take on more risk compared to building a large-scale enterprise.
- Consequences of excessive risk: contemplate the possible outcomes if things don’t go as planned. Could you risk losing everything and bringing your business to a halt? Would any potential debt be manageable? Reflect on these questions carefully before making any decisions.
These are all issues management should consider, typically in consultation with your board of directors. You can better understand how much risk is appropriate for your business, and make more informed choices regarding its future.
Risk-Reward Calculation
The risk-reward ratio is a metric that helps business leaders understand the potential profit they can make compared to the amount of money they could lose in a decision. It’s a simple calculation: divide the net profit (reward) by the maximum risk (the amount you could lose).
Using risk calculations for your business
When you invest in the markets, there’s a considerable amount of risk involved, and you expect to be rewarded for taking that risk. Imagine you found a stock you like, which is currently trading at $20, down from $25. You believe that if you buy shares now, they will go back up to $25 in the near future, earning you profit.
Let’s say you have $500 to invest, so you buy 25 shares. But do you know your risk-reward ratio?
Here are a few things to consider about the risk-reward ratio:
- It’s an objective calculation, based on numbers and not influenced by emotions or biases.
- Different individuals have different levels of risk tolerance. Not everyone feels comfortable taking high risks, so what may be acceptable for one person might not be for another.
- The risk-reward ratio doesn’t tell you anything about the likelihood of success. For example, playing the lottery involves a high risk with the potential for a massive reward, but the probability of winning is very low. On the other hand, investing in the stock market may have a more balanced risk-reward profile (that is, you might make a healthy profit, but you probably won’t make a killing), but it also has a higher probability of success than the lottery.
In addition to the above, remember that the expected upside of a stock may change over time as you gather new information. If you find that the risk-reward ratio becomes unfavorable while holding a stock, don’t hesitate to exit the trade. Always aim to be in situations where the risk-reward ratio is in your favor to make better investment decisions.
Key considerations for risk-reward calculations
To better grasp risk/reward calculations, you need to understand the following terms:
- Stop-loss order. This is the price level at which an investor decides to sell automatically. When a trade reaches this level, the stop-loss order triggers, preventing further losses by exiting the trade early.
- Profit target. This is the desired level that a trade aims to achieve. The profit target is the predetermined point at which investors plan to exit the trade and secure their profits.
- Entry point. This marks the starting point of a trade when an investor buys or sells a particular asset. It signifies the price level at which the trade is initiated.
6 Tips To Limit Risks for Your Business
Below are six tips to effectively limit the risks associated with running a business:
- Prioritize and rank risks
Prioritize risks based on their likelihood of happening. You can use a simple scale to rank the risks from low risk to high risk based on the probability of an event occurring:
- Most likely to happen
- Some chance of occurrence
- Small chance of occurrence
- Minuscule chance of occurrence
High-priority risks should be the top priority for risk management. That said, if a less likely risk has the potential to cause significant financial damage, allocate your risk reduction efforts accordingly. In other words, when evaluating the level of risk for your business, consider the severity of potential consequences as well.
- Get insurance coverage
Evaluate your business liabilities and legal requirements to determine the necessary insurance coverage. This may include property and casualty insurance, disability insurance, professional insurance, and cybersecurity insurance. Proper insurance helps transfer risks to insurance companies at a reasonable cost compared to potential uncovered risks.
- Diversify your assets
Avoid putting all your eggs in one basket by diversifying your products, services, customer base, and even geographic locations, if applicable. This way, if one area of your business faces difficulties, others can fill in the gap.
- Implement a quality assurance program
Build a good reputation for your business by prioritizing customer service and maintaining high product and service quality. Regularly test and analyze your offerings to make necessary improvements. Evaluate your testing methods to ensure they are effective.
- Manage high-risk customers
Consider implementing a policy that mandates upfront payments from customers with poor credit. You can prevent potential issues by establishing a process to identify these customers beforehand.
- Practice controlled growth
Assure proper employee training and focus on quality over quantity when setting goals for your team. Avoid pressuring employees to take unnecessary risks to achieve sales targets. Also, be cautious with rapid innovation; while it’s essential for success, overly fast innovation may lead to unsuccessful products or services.
The ROAR Platform Helps Businesses Understand and Manage Business Risk
Taking risks is essential for business growth, but it doesn’t mean you should accept risks beyond what you find acceptable.
The RiskOptics ROAR Platform is an all-in-one solution for facilitating IT and cyber risk mitigation, assuring compliance, and prioritizing tasks for your organization. It gives you a unified, up-to-date view of all the risks and compliance issues related to your business objectives, helping you understand the impact of these risks on your organization and make calculated risks to protect your systems, data, and overall organization.
Schedule a demo to learn how ROAR can help determine your business’s risk appetite.
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