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Risk Tolerance: Definition & Example

Instructor: Brianna Whiting
Some of us love to take on risks while others feel more comfortable taking the safe route. But how is risk handled in a business? In this lesson, we will learn about risk tolerance and how risk is managed to secure the investments of stakeholders.

Looking at Risk

Risk is a part of all of our lives. While there may not be significant risks each day, we all encounter at least a few every day. For example, let's say your alarm does not go off and you are late for work. You may run down the stairs to hurry out the door. Running down the stairs poses the risk of falling. Risk is everywhere, and while we as adults usually do our best to minimize serious risks, sometimes that is not always possible from a business standpoint. In this lesson, we will learn about risk tolerance which is the willingness of one to endure variability and volatility in investments, and how it can impact a business.

Risk Tolerance Defined

Let's start with a clear definition of risk tolerance. Risk tolerance is essentially how much risk one is willing to take on where their investments are concerned. With any type of investment, there is always risk, but how much risk one is able to withstand is their risk tolerance. For example, if you have a low risk tolerance, you may sell your stocks the very first time they start to dip. Or, if you like to live on the risker side of things, you may ride through very volatile times just to see how much money you can make. From a business standpoint, many times you make investments perhaps in stocks or bonds, or even in another company that provides a service to you. Each time you invest you are essentially making a decision on how to handle the company's financial assets. Because businesses do not know for certain how things will turn out, they are taking a risk.

Some factors that can fluctuate the risk of a business's investments include things like the market, the decisions the corporation makes, like merging with another company, and even political decisions if your investment ranges internationally.

Strategic Management and Risk

So how do companies manage risk? What is their role in ensuring the future of the company and protecting their stakeholders? Well, we all know that there is a correlation between the stake of the risk and the return. This means that the bigger the risk, the bigger the reward in the form of more money. While stakeholders want the company to succeed and do their best, they also do not want the company to make risky investments that end up collapsing the business. This is where strategic management comes in.

Strategic management is managing a company's resources so that it reaches its goals and meets its objectives, while effectively handling threats to the company. Strategic management means understanding the competition and developing strategies to effectively compete against the competition. Like mentioned earlier, part of strategic management is identifying and handling threats, and what bigger threat is there than losing money? Because investments are risky, they often result in losing money. That is why managing that threat means understanding the risk tolerance of the company and making sure the risk is not too great to jeopardize its stability.

Risk Management

Obviously, even the best strategic management plan cannot fully eliminate risk, but from a stakeholder's point of view, finding ways to minimize that risk not only protects their investments with the company, but also protects the company as a whole. But how does a company minimize the risk to a company? Perhaps the best answer to this question is by investing in a variety of assets. If a company makes investments in different assets, they can create a buffer, so to say. Basically, it is the thought of not putting all of your eggs in one basket. By investing in different things like stock or bonds, or even real estate, there is a chance that while one investment may not be doing well, the others might, thus still providing an opportunity to increase the reward while lowering risk.

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