Financial Decision Making: Balancing Risk and Reward

Posted on Mar 13, 2023 at 10:03 PM

Whether you're an entrepreneur, a manager, or a professional, understanding financial decision making can help you achieve your goals and stay ahead of the competition. It's not just about managing numbers but also about managing risks, opportunities, and resources effectively.

This article covers the essential steps to financial decision making and its applications in the corporate world.

What is financial decision making?

Financial decision making is deciding between courses of action in financial situations, such as investment, depending on various economic data.

These decisions are usually made by individuals and groups within a company, including board members and non-executive or accounting managers.

In other words, financial decision making is a behavioural process that involves making choices based on trade-offs between potential gains and losses (risks and rewards).

These risks typically make or break a business in the corporate market; that’s where financial decision making comes into play; it maximises shareholder wealth while minimising risk exposure and other costs.

What are the steps to financial decision making?

Now that we know that the primary objective of financial management is to maximise shareholder value over time by using different financial decisions such as investments, financing and dividend policies. We can only ask:

But how does that happen? 

Financial decision-making can be daunting for many people, requiring many skills. However, It is essential to understand how many factors can come into play when making money decisions and how to develop financial acumen to help with the process.

Here are the steps to make a sound financial decision making:

• Step one: create a plan

The first step in financial decision making is to consider what you want from your money. Is it to grow? Is it to protect? Is it to maintain? Or is it simply to spend? Or to create more profit?

• Step two: study your risk options

Once you have a clear idea of what you want from your money, the next step is determining how much risk you are willing to take with investing. Risk and reward are often linked, so as you increase the level of risk that you are eager to take on, so too should the potential return increase. However, if you take on too much trouble, there is also a greater chance that your investment will lose value or even become worthless altogether.

• Step three: estimate reward time

Once you have considered what type of return you are looking for and how much risk you are willing to take to achieve this return, it is time to decide how long you want your investment to last. The longer the term of an asset (i.e., the number of years), naturally, there will be more opportunity for growth or loss than with shorter periods (i.e., less than one year).

By developing your financial decision-making skills, you'll better understand financial concepts such as risk management, financial planning, and investment analysis. It’s a crucial part of any accountant training and will play a significant role in any company’s success.

Risk and reward: how do they influence a business's financial performance?

The two concepts of risk and reward are linked in a complex yet meaningful way. Risk is usually defined as the possibility of losing something. A reward is a potential gain—the more risk you assume, the greater the potential reward. Risk management helps decision-makers o make better decisions by identifying, quantifying, creating economical solutions and mitigating the risks to perform better and manage finances.

The relationship between risk and return is called the risk-reward ratio or Sharpe ratio after William F. Sharpe proposed it in 1966. The Sharpe ratio compares the excess return on investment to its standard deviation (a measure of volatility). The higher the Sharpe ratio, the better it is for investors.

• Risk: Achieving success through taking chances

Taking risks is often necessary to succeed in business or other areas of life. For example, if you want a promotion at a firm, you may need to take on more responsibilities – which means taking on more risk. However, this doesn’t mean that all bets are worthwhile; some might be too great compared to the potential benefits they offer.

• Reward: The potential gain from taking a chance.

 A reward is the possibility of gaining something valuable, such as profit or interest. The bonus can be either immediate (such as cash in your pocket) or long-term (such as increased wealth).

How to balance risk and reward? 

Balancing risk and reward is a crucial aspect of making financial decisions. Here are some basic strategies to consider when trying to balance risk and reward in the finance world:

• Diversification

One of the most effective ways to positively impact your investments is diversification. This involves spreading your money across different asset classes, such as stocks, bonds, and real estate. By diversifying, you can reduce your overall risk while still having the potential for reward.

• Research and analysis

Before making any investment decisions, assessing and evaluating the resources (like budget and funds) is essential. This may involve analysing financial statements, researching consumer behaviours, or consulting financial experts. You can make informed decisions that balance risk and reward by investigating.

• Setting realistic goals

When setting financial goals, you must be realistic about what you can achieve. This may involve setting targets for achievable income, savings, or investment returns based on your circumstances.

• Regular monitoring

Finally, monitoring your investments regularly may involve rebalancing your portfolio, selling underperforming assets, or taking advantage of new investment opportunities.

In today's fast-paced and complex world, making the right financial decisions can be daunting. But with the right tools, knowledge, and strategies, you can learn to navigate even the most challenging economic situations confidently and clearly.

Now that you have enough knowledge about the theory of financial decision-making and its application in the real world, it's time to make tough rational decisions in your personal and business life.