Balancing Risk and Return

In this post I will be discussing the basic terminology of risk management in Finance. Finance is about predicting the future, whereas accounting focuses on recording transaction of the past. In Finance, we always talk about uncertainty and this uncertainty can result in losses sometimes. Hence, in order to protect our investment, asset and instability the importance of risk management arises.

According to the Investment Guru, American business tycoon Warren Buffet,

“Risk comes from not knowing what you are doing”. In another word, it is indicating about uncertainty.

A renowned American Investment Banker, President of Goldman Sachs Gary David Cohn quoted as below,

“If you don’t invest in risk management, it does not matter what business you are in, it is a risky business”.

The definition of risk in a layman term can be defined as uncertainty concerning the occurrence of a loss in future. Loss exposures relates any situation or circumstances in which there is a probability of loss, regardless of whether the loss is occurring or not. Two different perspective of risk are objective risk and subjective risk. Objective risk refers to the relative variation of actual loss whereas, subjective risk is more towards to an individual’s mental condition or state of mind.

When it comes to the matter of risk management, it is pivotal to take into consideration of peril and hazard. A peril is defined as the cause of the loss. In a vehicle accident, the collision is peril. A hazard is a condition that increases the probability of occurring negative event. Hazard can be categorized into four type’s namely physical hazard, moral hazard, attitudinal hazard (Morale hazard) and legal hazard. Physical hazard is a physical condition that increases the frequency or severity of loss. On the other hand, Moral hazard is dishonesty or character defects in a person that increases the frequently or severity of loss. Attitudinal hazard (Morale hazard) is carelessness or indifference of a loss, which influences the probability of occurring loss. Legal hazard refers to the features of the legal system or regulatory framework conditions that increases the probability of incident to occur.

Classification of risk will be discussed in the posts near future, until then stay tune. Thank you very much. Happy reading!