So what is risk? Risk is the possibility that actual results will differ from desired or expected results. It implies the presence of uncertainty (uncertainty about the occurrence of event and uncertainty that it will display a particular outcome).
The degree of risk is determined by 2 factors:
- How often an event will occur?
- What is the probability the particular outcome will occur?
In business, it is generally accepted that as the risk increases, the expected or required return should also increase. It is not good for businesses to eliminate all risk because with elimination of risk, profits will likely decrease.
When thinking about risk and uncertainty the following description may help. Risk is binary. There is either risk or there is no risk. It’s either a yes or no. The degree of risk is the uncertainty. So we can say that yes, there is a risk it will rain in Paris today. We think there is high certainty it will happen. We are 80% confident it will happen. So there is either a risk (1) or no risk (0). The degree of risk (uncertainty) can be any number from 0 to 1. Risk is a possibility while uncertainty is a probability.
What is needed for an effective risk management process?
Risk management processes refer to the procedures that consist of systematic control activities and monitoring of risk management performance to ensure that risks in the organization are adequately managed.
According to Lore and Borodobsky, risk management have 3 dimensions:
- Upside management – taking advantage of opportunities where the business has very good chances to achieve success.
- Downside management – controls must be implemented to prevent or decrease losses due to operating environment.
- Uncertainty management – using techniques and methods to decrease deviations from expected results.
For effective risk management, organizations must deploy consistent risk measures, identify and manage all important risks, undertake proper management controls and support management of risks through performance evaluation on the business unit and organizational level.
Certainty and uncertainty
Certainty occurs when the outcome is 100% going to happen as expected. For example, the sun will rise tomorrow.
Uncertainty occurs when one does not have knowledge about future outcomes. Uncertainty is not the same as risk.There are different degrees of uncertainty, from almost certain to completely uncertain. Uncertainty increases the further into the future we attempt to plan. One’s access to information and ability to use available information in the decision making process determines the perceived degree of uncertainty.