What Could Go Wrong? The Basics of Risk Management
Risk management lets you reduce the severity of negative events or avoid them altogether. In both our personal and professional lives, we make decisions every day that can have far-reaching consequences. With the right approach, a grasp of the basics of risk management, and the know-how to protect ourselves, we can minimise losses and maximise our chances of success.
Risk management isn’t only about protection against unforeseen events; it’s also about consciously shaping your future by making well-thought-out decisions. Opportunity cost is helpful when making decisions, but for a decision to be truly well thought out, you also need to consider what might happen in life and how you can protect yourself against it.
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What are risk and uncertainty?
Every decision involves risk. Risk is a very complex concept, and many disciplines try to explain it. In everyday language, risk is understood as negative events. Negative risk is the domain of project management. Risk management in projects is one of the key aspects of this field. A project manager has to know how to guard against the negative effects of risk, while the positive ones are called opportunities.
In mathematics, on the other hand, risk can be either positive or negative. It is the product of the probability and the magnitude of the consequences of an event that deviates from expectations. Financial risk management is understood in much the same way. Finance is the science of how to use resources effectively, so anyone working in finance must be prepared for various scenarios, both positive and negative.
First and foremost, however, risk must be distinguished from certainty and uncertainty. A state of certainty exists when we know what the outcome of our action will be and there is no possibility (under normal conditions) of it deviating from what we expect (probability = 1). A state of uncertainty exists when we are not aware of the risk.
Most activities and decisions involve either risk or uncertainty. Most often, when making a decision, we can anticipate some of the possible consequences, but not all of them. Events we are able to foresee we treat as risk, whereas those we cannot foresee we treat as uncertainty (Knight 1921: I.II.38 – I.II.46). The more risks we identify, the better, because we will then be able to manage them. Sudden, surprising events that we do not expect cannot be managed.
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Risk can be divided in many ways, but I’ll cite just one of them – into internal and external risk.
What is internal risk? It’s risk tied to our own actions, which we have direct influence over. External risk, on the other hand, is beyond our control. We may be able to influence it, but our ways of protecting ourselves against it are fairly limited. External risk can originate in the actions of other people or in various phenomena. One example of such risk is a fall in the value of money; we have no influence over how the economy as a whole develops.
What could happen?
In everyday life we encounter a wide range of risks that can significantly affect our finances and sense of security, such as losing a job. Being laid off can throw your plans into disarray and lead to difficulties in maintaining your standard of living. There can be many reasons: a conflict with your boss, collective redundancies, or restructuring. But the most common one is old age. Most countries have a mandatory pension system in place, but it is usually not very efficient, which is why it’s worth considering how to provide for your retirement on your own.
Further risks include illness, an accident, or a hospital stay – your own or that of someone close to you. Health problems, especially sudden ones, may require costly treatment and place a significant strain on the household budget. That’s why it’s worth taking care of yourself. If you know that cancer, heart attacks, or diabetes have occurred in your family, it’s worth finding out how to avoid diabetes or other illnesses in order to reduce the likelihood of them occurring.
The next issue is the loss of assets. You might spill water on your new laptop, but you could also face a bigger problem, such as a car written off or even a house collapsing. Natural disasters, theft, or accidents can deprive us of what we have built over the years. And we also have to reckon with death. Not everyone dies of old age; illnesses and accidents happen that can strike anyone. The premature death of a life partner, beyond the immense emotional pain, is also a financial catastrophe, especially when the deceased was the family’s main breadwinner.
Significant events can also affect a larger number of people. A global financial crisis can lead to a fall in the value of savings and to difficulties in holding on to a job. What’s more, although it may seem unlikely, the outbreak of war or the loss of a state’s sovereignty could change our lives completely. Let’s remember that history is full of wars, and the Second World War ended barely 80 years ago. Before you start thinking about how to protect yourself against war, however, read on.
Identifying risk
A lot can happen in your life. In the face of such scenarios, risk management becomes an indispensable part of planning for the future, allowing you to minimise losses and prepare for unforeseen events. But we won’t be able to protect ourselves against every risk. Each of us has to identify risk in our own individual way.
List everything that could happen
Risk identification is a concept from project risk management. It reduces uncertainty, and its outcome is the selection of the risks we are going to manage. Risk management, both in a project and in life, makes it possible to prepare contingency scenarios. These are sets of actions that help reduce or even avoid the negative effects of particular risks materialising.
Identification consists of determining what risk we may be dealing with in a given situation. We can hold a brainstorming session or create a mind map. How to provide for retirement? How to avoid diabetes? How to protect yourself against war? How to protect yourself against the debts of your adult children? At this stage there are no silly ideas, because each of us has an individual situation. The result should be a list of the various risks that could possibly occur in your life. For now, without judging whether they are worth attention or not.
Estimate the probability of a risk materialising
Once you’ve written down the risks that come to mind, it’s time to determine the probability of them occurring (as a percentage or in words). There are risks that can occur with varying intensity. For example, the risk of catching a cold is very high, especially during flu season, but it will most likely have only a minor impact on your life. The risk of flu with complications in the form of pneumonia and a two-month hospital stay, however, is far less likely, but its impact on your life is much greater. Such risks are best recorded separately.
What impact will a given risk have on your life?
In the example above, I already gave away that the next step in project risk management is assessing the impact of a risk on your life. You should consistently stick to the rating scale you chose earlier (percentage or verbal) and determine what impact on your life the occurrence of a given risk would have. For now, focus only on the consequences.
In the fourth step, we determine the severity of the risk. This is done by calculating the average of the probability of occurrence and the impact of each individual risk. If we used an interval scale (probability: none, very low, low, moderate, high, very high, certain; impact on the project: none, very weak, weak, noticeable, strong, very strong, critical), then we assign ordinal numbers (0–6) to each category and calculate the average.
Magda identifies the risks in her life
Magda and Darek are six months into married life. Renting their flat costs them 2,800 PLN (plus bills). They found out from a credit expert that the instalment on a mortgage for a similar flat would come to 3,250 PLN, but they would pay far less in interest to the bank than they currently pay the flat’s owner. After 30 years the flat would be theirs, which will never happen with renting. They are considering buying a slightly larger flat, in which they could comfortably fit with a child. The instalment would come to 4,220 PLN (over 30 years), which still falls within their means. Darek earns 4,600 net as an air-conditioning installer, and Magda is a cashier at a hypermarket and earns 4,200.
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Darek is keen on the idea, but Magda has concerns about managing credit risk. On the Money? Simple! personal finance blog, she read that decision-making can be helped by calculating the opportunity cost (according to this concept, the mortgage is worth it) and by carrying out a risk analysis. She found out what risk is, sat down with a sheet of paper and a pen, and began to think.
Here are her notes
| Risk | Prob. | Impact | Notes | Severity |
| Job loss | low (2) | strong (4) | The mortgage instalment is my entire salary. If I lost my job, we would have nothing to live on. But I would quickly find work at another store, so a spell of unemployment would last three months at most. | medium (3) |
| Divorce | very low (1) | very strong (5) | We love each other, we are honest with each other, we talk when problems arise. A lot can happen and divorce is always possible, but unlikely. I think I would stay in the flat with our child; with my income and child support I would be able to keep paying the mortgage, although it would be hard. | medium (3) |
| Death of my husband | very low (1) | critical (6) | Darek is healthy, he drives carefully, he looks after himself. But something can always happen. On my own I have no chance of paying off the mortgage. | fairly high (3.5) |
| Rise in interest rates | low (2) | noticeable (3) | We have just lived through soaring interest rates, and that is exactly why I started thinking about managing credit risk. Rates are stabilising and are apparently set to fall. The risk of them rising is not high. The mortgage instalment would go up, but we shouldn’t have a problem with repayment. | almost medium (2.5) |
| Rise in property tax | moderate (3) | noticeable (3) | The government may introduce a cadastral tax. The tax would then become quite a serious cost that would have to be taken into account. | medium (3) |
| War with Russia | very low (1) | very strong (5) | The world is becoming increasingly unpredictable. I never even used to consider this, but if war broke out, it would be fought here. Little might be left of our flat. | medium (3) |
| A 20% drop in earnings | moderate (3) | strong (4) | I’m not afraid of being laid off, but if there were some kind of crisis, earnings could fall. If they fell by 20%, together we would have 7040, and the instalment would come to 60% of our income. | fairly high (3.5) |
Risk management, or making conscious decisions about risk
Once we’ve completed the identification and know the severity of each risk, we have to decide what to do about it next. Project risk management suggests four options: we can try to avoid a given risk, transfer it to someone else, mitigate it, or accept it.
A common way of managing risk in a project is avoidance, that is, not allowing a situation in which the risk could arise. For example: avoiding the risk of flooding means building a house outside a flood zone and without a basement or garage below street level. Since this involves abandoning the project or refraining from action, sometimes avoiding the risk is simply not an option.
If you don’t want to give up undertaking a given activity, you can think about how to protect yourself and choose risk mitigation (also called mitigating risk). It consists of taking action aimed at reducing the impact of a risk by lessening the consequences associated with it materialising. Mitigating the risk of flooding means laying high foundations, having no basement, and building a domestic flood-defence system – barriers and reservoirs.
Another way of managing risk in a project is acceptance, that is, coming to terms with the fact that it may materialise. We distinguish active acceptance, which is conscious, from passive acceptance, which is simply a lack of response to the risk. Passive acceptance can be caused by procrastination or indecision when it comes to handling the risk.
The last way of managing risk is its transfer. This is shifting all or part of the consequences of a given risk materialising onto another party. The most popular way of transferring risk in everyday life is buying insurance. In the case of managing investment risk or financial risk, the way to transfer it is hedging, that is, the use of derivative instruments – options or futures contracts.
Transferring the risk of flooding means buying property insurance with a flood extension. Only here it’s worth finding out what insurance risk is, because not all events can be covered by insurance. Every insurance contract contains numerous exclusions on the grounds of insurance risk being too high.
How did Magda decide to manage the risks in her life?
Magda chose two risks whose severity is fairly high (Darek’s death and a drop in earnings) and one of the medium-severity risks (job loss). She didn’t feel the need to manage risks with very low probability or with little impact. The former she doesn’t really believe in, and the latter she is simply able to accept. Which financial risk-management methods did Magda choose?
| Risk | Management | Description |
| Darek’s death | Transfer | Buying life insurance for Darek for the amount of the mortgage plus enough to keep Magda and the child going for three years. During that time she will be able to put her life in order so that she can manage (a pension for the child, cutting living costs). |
| Job loss | Mitigation | Building up funds that will allow her to calmly find a new job |
| A drop in earnings | Mitigation | Building up funds that will allow them to maintain their standard of living during the period of lower earnings |
Contingency scenarios in personal finance
The role of contingency scenarios in personal finance is played by financial strategies. These are plans of action drawn up in advance that are applied when a particular situation arises (e.g. when a given risk materialises). A single financial strategy can serve to manage several risks.
Magda opted to manage financial risk through mitigation, namely by building an emergency fund equal to six times Magda and Darek’s monthly expenses. Should the risk of job loss materialise (for Magda or Darek), they will have six months to find a new source of income. In the event of a drop in earnings, they will be able to draw on the fund until earnings rise again.
Summary
Risk management is an inseparable part of responsible decision-making. Knowledge about risk management in projects can be adapted to personal finance. By identifying and assessing risks, we can prepare for various scenarios, which increases our resilience to unforeseen events. Whether you’re looking for a way to protect yourself against the debts of your adult children or to avoid losing your assets, risk management will help you find solutions.
It is crucial to understand the difference between risk and uncertainty and to take a conscious approach to decisions about risk. It’s also worth knowing what insurance risk is, along with the insurer’s liability exclusions.
Introducing risk-management strategies such as avoiding, mitigating, transferring, or accepting risk makes it possible to minimise potential losses. In practice, effective risk management can protect us from serious consequences and allows for more stable and confident planning for the future.
In brief
Risk is a very complex concept and is of interest to various disciplines. In project management, attention is focused on negative risk. In mathematics and finance, risk is understood as the possibility of an event that deviates from predictions. It can therefore be either positive or negative. In personal finance, we draw on both the project-management understanding of risk and the financial one.
Risk must be distinguished from certainty and uncertainty. Risk is the probability of events occurring that differ from our expectations and that we are able to foresee. Events whose outcome is known to us and whose probability of occurrence is 1 we call certain events. Events we are not aware of are uncertain events. In personal finance, the division of risk into internal and external is important. Internal risk is the risk of our own actions; it depends on our decisions and we have direct influence over it. External risk stems from the actions of other people or from various phenomena, and our influence over it is limited.
The risk-management process consists of preparing for events that deviate from our expectations in such a way that they are as undamaging to us as possible. It comprises the identification and the handling of risks. Identification is recognising the risks that may occur. We do this by holding a brainstorming session or creating a mind map. To gauge their severity, we build a risk matrix, assigning each of them a probability and an impact on our activities. The severity of a risk is the average (or the product – we can choose) of the probability and the impact. The identification process ends with selection, that is, choosing the significant risks that need to be managed.
The risk-handling process begins with choosing a management method for each of them. This can be avoiding the risk, mitigating its effects or reducing the probability of its occurrence, accepting the risk, or transferring it (mitigation). The role of contingency scenarios in personal finance is played by financial strategies. These are plans of action drawn up in advance that are applied when a particular situation arises.
Key concepts
Risk, certainty, uncertainty, internal risk, external risk, risk identification, brainstorming, mind map, risk matrix, risk impact, probability of a risk occurring, severity of risk, risk handling, risk avoidance, risk mitigation, risk acceptance, active risk acceptance, passive risk acceptance, risk transfer, mitigation, financial strategy
Bibliography
- Kerzner H, Project Management. A Systems Approach To Planning, Scheduling And Controlling, Hoboken (NJ) 2009;
- Knight, F.H., Risk, Uncertainty and Profit, Boston 1921 (electronic access – 21.08.2024);
- PMI®, A Guide to The Project Management Body of Knowledge 4th Editon, 2008.