Imagine that you inherit 10 million dollars from your grandfather, who hasn't told you he was a millionaire. What would you do with that money? You'll want to make millions, and investing is the best way to do it. It's the year 2021, and the crypto market has boomed. Everyone expects crypto to go to the moon, and you want to take advantage of it. So you decide to buy $6 million worth of Bitcoin. This year you open your crypto account in late 2022 and discover that your $6 million is now worth $1.8. Had you known about risk reduction, your $6 million would be worth much more.
Risk reduction refers to strategies used to mitigate the risk one faces when one invests. Assets carry a different degree of risk, and diversifying is the best way to invest.
Are risk avoidance and risk reduction the same? Get to the bottom of this article to find out the ins and outs of risk reduction strategy with step-by-step examples. It will help you make sure that your business doesn't actually lose money!
Risk Reduction Definition
Risk reduction definition refers to methods used to mitigate the risk associated with investing in assets.
Different assets carry different type of risks, but some assets are riskier than others. What does it mean to be a risky asset and what does an asset mean? Let's consider their definitions below.
An asset is something of value that provides its holders with an income flow or capital gain.
Risky assets refer to an asset that has volatility in their value.
For example, cryptocurrencies are highly volatile. The price of Bitcoin last year was above $60,000, and this year, the price of bitcoin is below $20,000.
Risk reduction refers to methods used to mitigate the risk associated with an asset when investing money.
For example, imagine that it is 2005, and Anna has won the lottery. She has just made 1 million dollars and has to decide how to spend these 1 million dollars.
Anna consults with a financial advisor, who convinces her that real estate is the best asset to put her money on. And in fact, at that time, the real estate market in the united states was significantly attractive, making people richer and richer and richer.
So, Anna invests all her 1 million dollars in the real estate market. She buys some property and buys some real estate stocks.
Fast forward to the year 2008.
A financial crisis has hit the United States, and the market that's exposed most is the real estate market. Banks have given many loans out to individuals who can't pay them back. The number of people defaulting on their loans increases which causes housing prices to plummet.
If you want to find out more about what happened during the 2008 financial crisis and how the housing crisis plummeted, click here:
- 2008 Financial Crisis.
As a result, Anna lost the majority of her money.
At the same time, U.S treasury bonds and gold were outperforming all the other assets.
Had Anna reduced the risk by investing a portion of her money into real estate and another portion in U.S. treasury bonds and gold, Anna would not have lost all her money.
Risk reduction refers to investing strategies whereby an investor invests their money across multiple assets with different degrees of risk in order to mitigate the risk which comes with investing in one asset only.
A person or an organization must be fully aware of all the available financial information. That way they can calculate the risk that the asset bears and whether or not it is valuable for the company to invest in such an asset.
The assessment of financial risks is one of the parts of a risk reduction strategy that is both the most significant and most challenging.
Risk Reduction Strategy
One of the main risk reduction strategies is to reduce risk by investing in different assets with different degrees of risk. Multiple investments in different assets are called a portfolio.
A portfolio in finance refers to a collection of financial assets.
Let's consider an investor who invests his money in Treasury bills, also known as, T-bills and stocks.
T-bills are the safest one can invest in, as they are government bonds provided by the United States government. And the only way they can fail is if the government of the United States defaults, which is unlikely to happen.
The return on the investors' money is equal to the following:
\( R_p = bR_s+(1-b)R_t \)
The variable Rp refers to the investor's return on their portfolio. Where b is part of the money he invests in stocks(Rs) and (1-b) is the part of the money he invests in T-bills(Rt).
To measure how much risk is associated with stocks and T-bills we must calculate the risk. And, to measure the risk faced by stocks, we use the standard deviation.
The standard deviation measures how much the value of an asset deviates from its mean.
We denote the standard deviation by \(\sigma\).
- If the standard deviation is high, the asset deviates greatly from the mean price. Hence, the asset is risky.
- On the other hand, if the standard deviation is low, it means that there is not much deviation from the mean value; hence, it is a lower-risk asset.
The risk the investor faces in a portfolio can be expressed as the part of the money invested in stocks multiplied by the standard deviation of stocks.
\( \sigma_p = b\times\sigma_s \)
Fig. 1 - The relationship between risk and expected return
Figure 1 shows the budget line, which illustrates the relationship between risk and returns for the investor who chooses to invest between stocks and T-bills. On the horizontal axis, you have the standard deviation; on the vertical axis, you have the expected return.
Notice that as the standard deviation increases, the expected return also increases. That's because risky assets have higher expected returns compared to non-risky assets.
If the investor didn't want to face any risk, he would invest all his money in T-bills and get a return of \(R_t\).
If the investor wanted to reduce risk by investing in both, the investor will get a return Re while facing a risk of \(\sigma_e\).
If the investor wanted to risk it all and invest in stocks, the investor would face a return of \(R_s\) and a risk of \(\sigma_s\).
Risk reduction strategy also depends on the individual's preferences. Some individuals prefer more risk than others. This is represented by their indifference curves.
Fig. 2 - Choosing between risk and return
Figure 2 shows the risk reduction strategy that would maximize the investor's utility based on their budget line.
The investor is better off investing part of his money in stocks and the other part in T-bills, and his utility is maximized at an expected return of Re and a level of risk of \(\sigma\).
Why does the investor choose the I2 indifference curve. The investor would be even happier if he were in indifference curve I3, as it provides higher return; however, I3 indifference curve does not intersect with the budget line.
On the other hand, the investor can choose I1, but I1, provides lower returns than I2; hence, the investor chooses I2.
Indifference curves reveal how individuals choose between different combinations of market baskets while being equally satisfied. To find out all there is about them, click here:
- Indifference curve.
Risk Avoidance vs Risk Reduction
The main difference between risk avoidance vs. risk reduction is that risk avoidance involves not engaging in any investment that carries the slightest risk. On the other hand, risk reduction refers to reducing risk by investing in different assets with various risk levels.
Risk avoidance occurs when an individual does not engage in any investment in assets that are associated with the risk of losing money.
As the name suggests, risk avoidance is altogether avoiding the risk. One of the goals of a risk avoidance approach is to reduce the likelihood of vulnerabilities leading to risks.
For example, let's imagine that an investor is interested in purchasing shares in an oil firm, but recent months have seen a steep decline in the price of oil.
Oil corporation credit risk is building up, exposing the oil corporations to bankruptcy. Additionally, the political environment is not in favor of the oil stocks, as there is increasing tension between countries that are major oil exporters.
However, there is a massive opportunity for oil prices to go on the upside, but it comes with considerable risk.
It is known as risk avoidance when an investor considers the dangers inherent in the oil sector and decides not to purchase a share in a firm because of those dangers.
Risk Reduction Examples
Risk reduction examples include investors who invest in various asset classes to mitigate the risk they face in their portfolios.
Contrary to risk avoidance, when faced with risk, risk reduction involves using different strategies to mitigate the overall risk faced on their portfolio.
For example, let's assume that an investor owns a certain amount of shares in oil companies when the price of oil is volatile.
The volatility of the price of oil is due to the political setting as oil exporting countries are having political tension, which is also making oil companies viable in terms of their credit default risk.
To reduce the risk that an investor faces in their portfolio, the investor will consider buying shares in companies that move in the opposite direction of the oil price.
Think about it, when oil prices drop, the demand for cars increases, as people can spend less money driving. This will expand the profitability of car-making companies such as Ford or Mercedes, causing their stock price to increase. Hence, the investor decides to buy shares in these companies.
If the price of oil goes down, the investor can profit from his investment in Ford stocks.
This way, the investor manages to reduce the risk they face on their portfolio while not having to sell all their oil shares and jump into other industries.
Risk Reduction in Business
Risk reduction in business refers to the methods business uses in order to mitigate the risk they face during their operational activities.
All businesses are allowed to have a certain degree of risk known as the residual risk of the business. The business decides what the level of this residual should be based on the macroeconomic and microeconomic environment.
For example, suppose the economy is heading toward a recession. In that case, the business should do everything possible to reduce its residual risk. Otherwise, they'll find themselves filing for bankruptcy.
There are some means of risk reduction that a business can reduce the risk they face. It entails taking preventative actions to lessen the severity of the effects of the consequences.
One method of lowering risk is known as risk transfer.
Risk transfer is a business agreement where one party pays another party to bear responsibility for reducing certain losses which may or may not occur.
One of the most common examples of risk transfer involves buying insurance. A business may purchase insurance for the factory they're using to produce their selling product. In the event of a natural catastrophe, the business can claim the money back from the insurance company.
Risk Reduction - Key takeaways
- An asset is something of value that provides its holders an income flow or capital gain.
- Risky assets refer to an asset that has volatility in their value.
- Risk reduction refers to methods used to mitigate the risk associated with an asset when investing money.
- Risk avoidance occurs when an individual does not engage in any investment in assets that are associated with the risk of losing money.
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