Alfreda Zachorowska

The Czestochowa University of Technology

Investment risk management – chosen aspects

Uncertainty and risk are the normal phenomena following economic undertakings, especially investment activity of enterprises functioning in market economy conditions. Risk and responsibility for the present and future results of activities are the basic principle of market economy. Recognizing the idea of investment risk and its mechanisms, are necessary in order to restructuring the enterprises towards active and innovative undertakings. 
 

1. The idea and kinds of investment risk

Term risk and uncertainty, thought they are often thinking they are identical, do not determine identical phenomena. These categories concern chronological and alternative followed phases of the same decision-making process[1]. The risk changes together with uncertainty, so that’s why it can be the function of uncertainty. Especially, this function has the character of simple relationship: the broader range of uncertainty, the higher risk, and vice-versa. When undetermined and uncertain factors decrease – the risk is going down.

Investment risk is the element of economical risk and it is tightly connected with potentially danger during gathering in future forecasted economic effects[2]. The risk character is very differential. We can meet with one directional risk (loss), and multidirectional risk (profit, loss)[3]. The risk is often shown as the essential condition of economic development, and on the other hand as the source of economic success of the enterprise. Risk can lead to success by detailed analysis of chances and threats, and that’s why by using the restructuring of its threats into development chances.

Investment processes are very complex and differential. So we can make mistakes during these processes. It can be, for example, not proper localization of object, not proper or irresponsible contractor. The possibility of mistakes concern both decision-making process and the process of realization given investment. Every next choice making during the investment process is determined by investment decision, which was made in the beginning. Future success depends on its accuracy and it is the critical point for the whole investment process.

Certainty is the state of being when the manager have information that are helpful in order to proper forecasting the effects of his decisions. Risk means, that manager can determine the range of some consequences of his decisions. Uncertainty is when we have the situation, that manager can’t determine the possibility of his decisions.

So, the investment decision-making process is very essential, and the biggest threat for the investor is risk of unsuccessful effects or even more the loss of assets. That’s why the uncertainty can lead, in some cases, to stagnation in new investment or inhibition of investment processes, that were started.

2. The idea and range of investment risk management

Risk management is the generally accepted term, used in investment practice. It means the identification of phenomena, that can be dangerous for the financial effects (profit) of this activity, or planning precaution that can limit negative effects of given risk. However, investors practice micromanagement in relation to individual risks, rarely (because of high costs) they practice global risk management[4]. The central decision problem, in risk management, is the appraisal and choice of alternative methods, strategies, projects and means of reduction the risk. Every time, the risk should be, as early as possible, identified, analysed and systematic controlled. Simultaneously the manager should correct methods and instruments of its reduction, accordingly to changing conditions. It is a process ex ante, that depends on recognizing and prevention of negative risk factors, or depends on using factors that have positive impact on investment process[5]. Simultaneously it is also directed on the absorption of negative effects of deviation and can be ex post activity. In both variants of risk management (ex ante and ex post) it regards the minimisation of negative effects.

In case of investment processes, risk management should exist in every phase of investment cycle. The implementation of risk management in the early phases of investment cycle is more effective, though more strategic than operational character, because of limited range of information. In these phases we can make some changes, improve technical and economic assumption, and verify solutions, what can lead to risk reduction[6]. In this aspect, it is very essential the last phase of preinvestment stage – phase of creating the technical conception of investment project[7]. It is a phase with determined program, the investor have additional analysis (simulations, analysis taking into consideration probability mathematics, etc.), that are in relationship with the most uncertain areas of given project.

From the point of view of uncertainty and risk it is necessary in the last phase of preinvestment process, when making detailed technical project , to make the plan of risk management. Such plan can show, from the one hand, what kind of strategy should be undertaken (with suppliers and contractors on the stage of realization) and on the second hand – it can make easier making choice of most advantageous contracts[8].

3. Stages of investment risk management

Risk management should have planned and target character. It means, that these activities should be systematic and long-term, and the effect is maximal risk reducing and protecting against its negative impact. Often we can distinguish three stages of this process[9]:

- risk identification and quantification,

- risk steering,

- risk controlling, in order to its maximum.

The first stage, of informative and forecasting character, is the risk identification, determining its specific, character and kind. Proper identification and appraisal are depended on the range, completeness and quality of data. The identification of risk enhance on gathering proper methods of its measurement (quantification). After identification of risk sources for given investment, we can analysing risk of every kind. The appraisal of the influence different kinds of risk on the realisation process is very essential. Risk quantification is one of the most difficult stages of risk management. Many techniques have to be used here, and the selection of these techniques depends on many objective and subjective factors. Objective factors can be following: type and size of investment, range and plausibility of gathered data, time-consumption and also costs of risk analysis and appraisal, and experience and knowledge of analysts[10].

The group of subjective factors includes among others economic potential and financial condition of investors. After risk quantification one is possible to qualify the direction of further activities and go to the second level - risk controlling. This stage consists of taking decisions which limit risk and have an active or passive character.

The control of efficiency methods and forms of risk minimizing is the last management level of this process. It includes a lot of states aiming at effectiveness evaluation and efficiency of applied methods along with instruments reducing risk. Generally, one also distinguishes here physical and financial control of risk. The physical control of risk consists of all actions and instruments which lead to the total elimination of loss probability (it means risk avoiding or prevention the losses), or its large limitation (with the use of frequency measures calculating losses’ size).

The financial control of risk includes all activities and instruments leading to risk stopping (independent risk management) or to risk transfer. The control system enables therefore the evaluation of effectiveness of actions reducing risk.

It should be underlined, that there is no universal procedure of risk management in all conditions and for each investor. The procedures ought to be constructed individually, adapted to external and internal conditions of particular investment activity.

4. Chosen methods of investment risk minimizing

On the one hand investment risk is the result of uncertainty noticed by investor, on the other hand - it results from the size of the capital engaged in investment process. These connections determine the directions of negative results reduction as far as risk is concerned. The reduction of investment risk may be done by[11]:

- reducing the amount of capital involved in risky undertakings,

- uncertainty minimization,

- risk burdening over different economic entities.

The minimization of risk in functional aspect consists in undertaking some activities focused on its negative results’ correcting. Also some actions taken to anticipate the harmful consequences of risk belong to this group. One should underline, that the proper risk identification and its evaluation is the information basis needed to choose methods and forms for risk mitigation. Generally in literature one distinguishes three ways of evening risk out[12]:

- risk compensating with the use of location (diversification) of enterprise capitals in productivity fields and risk fund optimizing,

- risk division, among others through dispersion of common shares,

- transfer of risk for insurance institutions.

There can appear four typical reactions of investors corresponding with reducing methods or the total reduction of this phenomenon in the process of risk management. These are[13]:

- risk avoidance,

- risk stopping,

- transfer of risk,

- risk reduction.

In dependence from degree of threat the risk, the investor decides on use one of methods of reaction on this phenomenon, introduced on drawing 1.

Depending on the level of risk threat, the investor decides to use one of reaction methods presented on Figure 1.

Figure 1. Methods of investment risk reducing

Source: prepared on the basis: K. Homann: Risikomanagement im Immobilienunternehmen. Berufsakademie Stuttgart, University of Cooperative Education, Akademie der Immobilienwirtschaft (ADI) GmbH, Stuttgart – Leipzig – Hamburg 2003, p. 27.

Risk avoidance is a situation, where the conscious refusal of even temporary risk acceptance appears. It is the easies, but the least effective form of risk management, however the probability of possible losses is zero in this case. This method belongs to negative techniques of reactions to risk[14].

Often occurring method of risk reducing is so called retention, which means risk stopping. It is rather more popular in large and financially strong corporations than in small enterprises. This method means, that enterprise chose the variant of possible losses covering with own financial resources. The most popular form is to create a special purpose fund (reserves) for financing the costs of probable failures. Its additional function is self-insurance enabling to cover losses. There is no uniform opinion in literature according to the range and subject of reserves. They can be created by all participants of investment process and they can simultaneously concern not only investment expenditures, but also the costs of exploitation and even the time of investment realization[15].

Even though there exists a wide range of factors influencing the size of reserves, the decisive role is fulfilled by the exactitude of parameters of investment project. These resources can be the smaller, the better are individual parameters of project quantified. The uncertainty decreases in the next phases of investment realization, because the estimates are more exact. One can create smaller reserves because of that.

The compensating of risk negative results with reserves’ creation (special purpose fund) in relation to chosen variables of investment project reflects the possibility of avoidance of additional payments in case of cost limit crossing incurred by the investor. The aim of applied reserves is therefore to cover the additional costs being the result of unforeseen events in investment realization. It may concern both its realization time, as well as the exploitation costs of realized project. The creation of reserves involves however the maintenance of part of financial resources. It may contribute to the increase of realization costs and extension of realization time. Therefore its is essential to create these reserves on the optimum level, taking into regard both the protection against risk, as well as the burden of capital financing investment realization.

Also of great importance is the awareness of the possibility of unexpected losses and the necessity to cover them with current resources, usually net profit, or resources from the sale of assets in order to replace the lost or destroyed ones. These are the consecutive ways of implementing this method. However it can not be used for risks with hard to predict effects and potential losses. It also refers to cases of relatively high potential losses and high probability of their massive accumulation.

Risk retention, both complete and partial, can have an active form, as a result of conscious actions, or passive, usually resulting from the lack of knowledge of the character and size of this phenomenon. Active method is used mostly towards risks of high frequency and low sharpness, i.e. when potential losses are low. Passive risk retention is usually means the investor’s passive attitude towards risk, that can also be caused by the character of this phenomenon. It usually applies to risks of low frequency, which are unnoticeable by the person in risk.

Another method of limitation of investment risk is transferring it to other business units, called risk reallocation. Distributing risk across different units is one of the basic forms of risk management. It means the transfer of total or part of responsibility for covering possible losses. It can have two forms: transfer of activity generating possible losses or transfer of responsibility for covering possible losses. Negative financial effects of risk can be transferred using e.g. financial derivatives, classic insurance method, or proper leasing agreement.

Risk distribution instruments also include agreements with future users, sponsors, and term purchase agreements. Thanks to those the investor gets the possession of resources during the investment process, in exchange for the specified part of outcomes of finished project.

In investment processes, risk transfer usually takes the form of[16]:

- proper conditions of contracts between parties of the investment project,

- risk insurance.

That way the whole or the part of risk is transferred to insurance company, agreement counterparty, or other unit. This method allows to run the investment process in full range, with simultaneous transfer of problems of evaluation and cost of risk to other unit[17]. Proper allocation of risk across parties of investment process can be done with contracts, although their formulation is not easy. Agreements between investor and contractor serve i.a. two main purposes[18]:

- they determine the liabilities of both parties, including mutual obligations,

- they determine the way the risk related to particular activities will be allocated across the agreement parties.

Risk transfer can also take place in form of subcontract – hiring other unit for particular range of works, generating possible losses. The same effect can be achieved with proper clauses in contract, regarding works of high risk, leading to situation, where investor is free of the responsibility for losses included in the agreement.

Parties of the investment process have different interests, which leads to difficulties in constructing contracts. By the same reason, in case of risk occurrence there are difficulties with its cause determination, and the allocation of its effects across investment process parties. Risk allocation through contracts can also be obstructed by the nature of events being the source of risk. Some events are easy to identify and evaluate. However some risk sources are difficult to detect, and their negative effects can emerge in later time. In such cases prior precise determination of nature of events, potentially being the sources of risk, risk transfer cost and risk managing parties can all be very helpful[19].

The commonly used instrument of risk limitation are guarantees, given by government or other parties with proper financial standing. Those parties through guarantees take a part of investment risk.

Risk transfer can also take form of risk insurance. It is the basic and also the most often used form of risk transfer. The distribution of negative effects of random events across numerous units leads to their full removal or partial reduction[20]. Insurer sells the protection from the negative effects of risk, and the insurance taker buys the protection. Insurance premiums are the cost of transferring the negative effects of risk to insurance company. Risk insurance is particularly important in the case of real investment. Apart from construction project one can also buy insurance for different parties of investment process and the loans drawn for this purpose. During the investment process there is a possibility of occurrence of various unexpected and unfavorable events negatively affecting the effectiveness of the process. Risk can also refer to project works. Losses caused by the mistakes in planning can be so significant and expensive, that their removal can be impossible due to the financial capability of the contractors. Thus the subject of insurance can be not only the various construction objects, but also construction in progress and the parties responsible for the planning. Insurance subjects can also be machinery and construction equipment, investor property, and construction facilities, such as administration and social buildings, warehouses, workshops and their equipment. One can also buy insurance from third-party liability caused by accidents on construction site. Insurance subjects may also refer to maintenance, modernization and reconstruction of objects.

Insurance protection includes all stages of investment cycle, and also the operation stage of the object. During the investment process, the most popular insurance is all-risk insurance, where insurer does not list threats that he is responsible for, but list events that are not covered by the protection. On the other hand, in the operation stage of the object insurance companies refer to their conditions of property insurance.

Risk reduction can also be achieved through diversification of investment portfolio. However in case of real investment there is no possibility to distribute risk like in financial investment case, that is by creating optimal investment portfolio. Investor often has to engage the majority of his resources with the investment process, without the possibility to secure the desirable profitability. Nevertheless the main element of risk protection strategy is investing only when expected rate of return is higher than the cost of capital increased by the risk premium. This idea can be realized only when investor is able to distribute risk across numerous optimal investment projects. The method is of limited use though, as it is available only to financially strong investors (such as concerns or financial institutions). Small investors usually do not have enough capital in their disposal to invest in many projects. However simultaneous investing in different assets, and splitting capital into different projects significantly reduces the risk. There can also be a complete limitation of risk there, as negative effects on one asset can be balanced by the same effects positively affecting another asset[21]. Activity diversification enables investor to increase his adaptation capability, thus to limit the uncertainty and reduce risk.

Conclusions

It has to be noted, that there is no way to eliminate risk completely, only to reduce it significantly. According to the level of risk, investor can use different methods of its limitation. If the possibility of risk is insignificant, investor can accept it and take it by himself. But if the analysis shows that the possibility is high, and risk can bring great losses, investor should adequately earlier avoid it or reduce or transfer[22]. When selecting the risk limitation methods, one should take into consideration the nature of the problem, time needed for its e