Risk can be...well, risky!

For the last few weeks we've been hearing how much risk there is in the economy.

One of the key words being thrown around is "systemic" risk, and I thought it might be wise to analyze the two basic types of risk one faces when running or managing a business. For some readers this will be a refresher course on managing and measuring risk; for others, we're going to slap some formal terms onto things you probably already know. Consider it a free Finance course.

The first goal of ANY venture is to remove as much risk as possible from the equation. By doing so we increase our assuredness that our project or investment will be predictable. We like predictability since it helps us create reasonable, realistic figures that we can present to our banker, shareholders or business partners. The way to remove risk is by doing something called "diversifying." Many of you know that word from meeting with your financial professional and them telling you to diversify your portfolio. It's a fancy way of asking you to not own only one type of stock, but rather, many different types of stocks. This creates a layering effect, so that one investment goes down, another might go up. It's a way of offsetting one risk with another.

Any risk that can be removed through diversification is known as non-systemic risk.

Let's look at a pizza shop for example since it's Sunday and pizza goes with church and football.

A pizza shop owner wants to remove as much risk from his or her business as possible. What are some risks they face on a daily basis that can be tweaked or changed?

Costs are largely contained in ingredients, so if the cost of mozarella cheese goes up from one supplier, our owner can look to another, cheaper substitute. Similarly, if business is slow during the lunch hour, our pizza shop could expand into new products such as salads, sandwiches, finger foods, etc. If our pizza shop is in a large metroplitan area, they may decide to eliminate delivery altogether and save the cost of labor. Basically, anything that can be readily changed to keep costs down/revenue high is a non-systemic risk.

On the flip side of the coin, however, is "systemic" risk. This is risk that CANNOT be eliminated through diversification.

For example (and there are many) oil prices. There is absolutely nothing our pizza shop owner can do about the cost of oil, which ultimately results in higher produce costs. Similarly, minimum wage increases set by government bodies will have an impact on the bottom line and there is nothing our business operator can do about those either. Other examples include inflation, unemployment, acts of terror, war, election results, interest rates,etc.

So as business people, it is our job to eliminate or diversify ALL of our non-systemic risk while carefully planning for ALL systemic risk.

We are very good at the first part since we know our business forwards, backwards and inside out. But for some reason, we are not real good at the second part, whether it's a result of too little time to plan for this type of risk or we aren't really interested in figures like CPI, PPI, GDP, Prime Rate and unemployment figures (both locally and nationally.)

I'm here to tell you that if you are to be successful for the long-haul, you have no choice but to be concerned about systemic risk. Otherwise, you are living a lie even though you have every product that could appeal to any consumer in the world.

Make a plan that includes tracking interest rates, inflation figures and employment figures; whether daily, weekly or at the least monthly. This will help you begin to see where the economy is heading six, nine or twelve months from now. By doing so, you would have known that this crash was likely to occur and you could have applied for that business line of credit in May rather than scrambling now to shore up some extra cash. Maybe you held off on that new piece of equipment because you were too busy to stop by the bank and make a loan application. Now, the cost of the equipment has gone up due to production costs and you are having a tough time getting approval for the loan since lending is being restricted.

Plan for the long-run by analyzing systemic risk and run your business day to day by measuring non-systemic risk.

It's really nothing more than a study in Macroeconomics (systemic) versus Microeconomics (non-systemic.)

Next week we will uncover some figures that help us put a number to the amount of risk we're taking on.