Risk management is happening everywhere in the world of finance. This happens when an investor buys US Treasury bonds instead of corporate bonds, when a fund manager hedges his currency risks with currency derivatives, and when a bank checks the creditworthiness of an individual before issuing a personal credit line. Stockbrokers use financial instruments such as options and futures, and financial managers use strategies such as portfolio diversification, asset allocation and position sizing to effectively reduce or manage risks. Inadequate risk management can have serious consequences for companies, individuals and the economy as a whole. For example, the mortgage crash of 2007, which helped trigger the Great Recession, arose because of poor risk management decisions, such as lenders who provided mortgages to individuals with a bad credit history. Investment companies that have purchased, packaged, and resold these mortgages; and money that has been over-invested in realigned mortgage-backed securities (MBS) but remains risky. Example For example, during the 15-year period from August 1, 1992 to July 31, 2007, the average annual gross yield of the S&P 500 was 10.7%. This figure shows what happened throughout the period, but does not explain what happened along the way. The average standard deviation of the S&P 500 index over the same period was 13.5%. This is the difference between the average yield and the true yield at most of these points over a 15-year period. When using the bell curve model, any given result should be within one standard deviation from the mean in about 67% of cases and within two standard deviations in about 95% of cases. Thus, an investor in the S&P 500 can expect that the yield at any given moment during this period will be 10.7% plus or minus a standard deviation of 13.5% in about 67% of cases; it can also be assumed that 27% (two standard deviations) will increase or decrease in 95% of cases. If he can afford to lose, he invests.
Understanding the risks is a significant part of the general success of an enterprise. An entrepreneur who understands all the pros and cons of a certain business model will be able to get as much as possible from it without risking losing too much. And a significant part of calculating risks is made by knowledge in accounting and finance. That’s why taking some classes or courses in modern finance is extremely important. The money you pay for classes will return to you tenfold. It’s one of the most significant parts of being a successful businessman.
