Using Measuring Risk in Strategic Management - Essay Example

Financial decisions taken by a business or an investor involves risk and it is not possible to think of a way to eliminate risk but can be reduced by developing certain strategies. Investors don’t prefer risk but are unlikely to avoid it thereby looks towards ways which ensures a proper match between risk and return. Investors while taking a financial decision want to know the reason for the risk, the manner in which it will be measured and strategies which will help to reduce risk. This has given rise to the concept of systematic and unsystematic risks which an investors looks into. This paper presents the manner in which systematic and unsystematic risk affects the decision of an investor and the impact it has on the share market. The paper also explores the different alternatives through which the risk can be controlled so that its effect on the share prices can be better understood. This will help to improve the understanding regarding the different factors which goes in an investors mind while looking to invest in the shares of the company and will help to explain the likely expected return that makes the investor take the risk. Risk and return are the fundamentals of finance as it helps to evolve the decision regarding financing of different instruments. Investors look towards high return for high risk bearing securities but the situation could in the actual scenario turn otherwise. This would mean that the investors instead of gaining money on the high risk instruments loose money. Thus, risk is present in every outcome especially the ones in which the customers don’t know the possible outcome (Baird and Thomas, 2000). This has made investors look towards creating a portfolio of different assets having different degree of risk and return so that on the overall basis the risk and return are both controlled and the investor is able to earn a good income on the invested sum. Diversification helps to control risk to a large extent especially when the securities which are included in the portfolio are negatively correlated. Even some shares which have a positive correlation are seen to reduce risk when taken in a portfolio and is primarily due to the fact that they are diversifiable risk or unsystematic risk. This helps to understand the fact that the risk which can be controlled through diversification and developing a portfolio of shares are referred to as unsystematic or diversifiable risk (Markowitz, 1991). On the contrary risk which are inherent part of an asset and cannot be diversified by taking any steps are termed as non diversification or systematic risk. An example will help to understand it better. Suppose a recent research development or exploration of the business ensures either positive or negative growth for the company will have an effect on the risk and the return that the investors get from the shares of the company. This risk can be reduced if a portfolio of shares is made where different assets belonging to different companies are put together (Walls & Dyer, 2006). This will help to ensure that the risk of the business is controlled and is termed as unsystematic risk whereas the risk which cannot be controlled irrespective of the steps taken it is called systematic risk. An important thing to note here is that unsystematic risk is different for each business and arises due to the manner in which the business conducts their affairs. This makes the unsystematic risk to differ from one business to another and is particularly business based. On the other hand systematic risks are the general risk that all business has to face and is similar for all businesses. This risk arises due to economical factors, environmental factors and social factors and affects each and every industry in a similar manner. Thus systematic risk is similar for every business and cannot be controlled be eliminated due to factors which have a relevance on the business performance and affects the final decisions taken by the investors. The following figure shows that creating a portfolio of 25 to 30 stocks helps to reduce the unsystematic risk. This is because of the fact that having a properly designed portfolio ensures that the effect of an event pertaining to a particular company doesn’t have any effect on the risk and return. Instead the return of a portfolio which has been diversified helps to take care of different factors like changes in interest rates, taxes and other factors which ensure better opportunity for returns. The systematic risk thereby is influenced by the sensitivity that the market has and helps to understand the manner in which the risk and return gets affected. This is shown in the diagram below (Damodaran, 2001) The manner in which unsystematic risk is diversified can be understood by examining the fact that a portfolio has around 25 to 30 shares of different companies. The shares of a company are held in some proportion. The effect of this will be such that an individual event which takes place in a particular company will have little effect on the variance or standard deviation of the portfolio (Damodaran, 2001). This will result in minimum deviations and the risk which arises due to events of a particular company and has been termed as unsystematic risk can be controlled. This will help to reduce the effect of a particular event and will help to control the risk that the investor face while investing in the shares of the company. This risk thereby has an effect on the share prices as the holding of shares in the portfolio varies depending on risk appetite of the investor. Since, there are no limits to the number of shares that the investor wishes to have in the portfolio so an investor looks have adequate portfolio holdings which ensures that the investor remains on the efficient frontier as shown below An investor always looks to stay between the point A and B as there is a proper relation of risk and return and ensures that the investor remains at the efficient frontier where the risk and return are balances. An investor while looking to include shares in the portfolio always aims at it as at any point either below or above would mean that the investor has to either accept a lower return or a higher risk which are both against his personal interest and risk appetite (Miller and Bromiley, 2000). Using this method helps the investor to ensure that the unsystematic risks is controlled which thereby enables that he has to deal with only the systematic risk which is similar for all business and securities in the market. The efficient frontier as depicted in the above chart shows the point at which an investor would like to stay. For example, a risk averse person would want his portfolio to be somewhere near A whereas a person with a higher risk appetite would want his portfolio to be around point B. Thus, the efficient frontier line helps to identify the risk taking ability of an investor and based on it develop a portfolio of securities which will ensure that the investor gets an adequate frontier line and is able to get proper return on the risk taken by the person (Holloway, 2009). Both systematic and unsystematic risk has an effect on the share prices as it has an effect on the securities that are held in the portfolio. Since, investors look to have securities in such a manner that the effect on the risk and return is balanced so investors prefer to have some securities which ensure that the unsystematic risk reduces (Prasad, Bruton and Merikas, 2007). This has an impact on the prices of shares as the fluctuation in the buying pattern with certain securities being purchased more than other creates positive sentiments among the people which results in increasing the price of the shares in the market due to increased buying. Both unsystematic and systematic risk has an effect on the share prices as the risk due to these factors makes the investors react in a different way. For example, when we consider the fact that a discovery in a new field increases an opportunity for the business to earn higher profits and ensure better growth opportunities will automatically get reflected in the share prices as it will go up. This will make the investor feel that the company is going to do well in the near future which will automatically increase the share prices and have a positive effect on the market. The opposite is true for another situation. Thus, unsystematic risk results in both an upside and downside risk for the business which has to be taken into consideration as it has an effect on the share prices. The manner in which the different risk has an impact on the business outcomes has made the investors to also look towards different tools and measures which will help to determine the optimum mix of shares they should have. This will help them to understand the manner in which the risk has an impact on the business prospects. An important thing to consider here is that the systematic risk which are non diversifiable is an area of concern for the investor as the investors are unable to make a strategy for it. Further, the impact of the systematic risk is similar for all securities which results in the fact that the risk of all securities is the systematic risk (Orman & Duggan, 2009). The investors can take care of the unsystematic risk but since the systematic risk cannot be controlled it has become a part of the risk bearing appetite. The investors have to purchase securities after keeping in mind that the systematic risk will be prevalent there. This is one of the prime reasons which shows that the investors investing in the securities decreases during the downturn of an economy. This is precisely due to the fact that the systematic risk for the investor at this point of time increases. The investors as a result are not able to operate on the efficient frontier and have to bear a higher risk for a lower return. This inability to control the systematic risk makes the share prices to further go down and has an impact on the final prices of the shares. This thereby creates a situation where the systematic risk is uncontrollable which makes the investors stay away from the market and thereby has an impact on the share prices. The opposite happens in case of an economy which is growing as the positive sentiments of the investors makes the prices of the share to shoot up. This is because of the fact that the systematic risk is low which helps the investors to be able to get a good return on their investments as risk is low. Thus, systematic risk has a large role in shaping the manner in which the share price behaves as it determines the market capability and the risk appetite of different investors which will have an impact on the share prices and make the market react in a different manner (Lutbakin and Chatterjee, 2004). Investors have to look at both the risk while looking to invest in the securities of any company. A major decision regarding the investment decision on different securities depends on the risk appetite. This also helps to understand the different portfolio holding that the investor looks to have. This has thereby helped to understand that diversification by holding different securities in a portfolio helps the investor to reduce the unsystematic risk. Along with it the investor wishes to stay on the efficient frontier which helps to understand the risk and return on the securities that has been held by the investors. On the other hand investors are unable to control the systematic risk as it is an inherent risk which is similar for all companies working in the economy. This risk also has an effect on the share prices and the different risk results in different share holding in different holding which affects the demand for particular securities thereby having an impact on the share prices. Thus, investors have to deal with both the systematic and the unsystematic and ensuring diversified portfolio of securities helps the investors in controlling risk. References Baird, I. and Thomas, H. (2000). What is Risk Anyway ? Using and Measuring Risk in Strategic Management, Greenwich, CT : JAI Press Inc. Damodaran, A. (2001). Corporate Finance, Theory and Practices, John Wiley and Sons, 2nd edition Holloway, C. (2009). Decision Making Under Uncertainty: Models and Choices. Prentice-Hall, Englewood Cliffs, NJ. Lutbakin, M. and Chatterjee, S. (2004). Extending Modern Portfolio Theory Into Domain of Corporate Diversification : Does it Apply?, Academy of Management Journal, 37, pp.109-136 Miller, K. and Bromiley, P. (2000). Strategic Risk and Corporate Performance : An Analysis of Alternative Risk Measures, Academy of Management Journal, 33, pp.756-779 Markowitz, H. (1991). Portfolio Selection: Efficient Diversification of Investments, Second edition. Blackwell, Oxford. Orman, M. & Duggan, T. (2009). Applying Modern Portfolio Theory to Upstream Investment Decision Making. Paper – Society of Petroleum Engineers, vol. 54774 Prasad, D., Bruton, G. and Merikas, A. (2007). Long Run Strategic Capital Structure, Journal of Financial and Strategic Decisions, 10 (1), pp.47-58 Walls, M. & Dyer, J. (2006). Risk propensity and firm performance: a study of the petroleum exploration industry. Management Science 42 (7), pp. 1004–1021 Read More