What is risk management?

In the financial sector risk management refers to the identifying of, analysis, and acceptance or reduction of risk in investing decisions. In essence, risk management happens when an fund manager or investor analyzes and attempts to determine the possibility of losing money when investing, for example moral hazard, and then decides to take the appropriate step (or or inaction) in accordance with the investment goals of the fund and the fund’s risk tolerance.

The risk is not separate from the return. Every investment comes with a degree of risk. It is considered to be zero for the U.S. T-bill or quite high for things like emerging market equities and real estate in high inflation markets. Risk can be measured both in absolute and the context of relative. An knowledge of risk in its diverse forms can help investors better know the trade-offs, opportunities and risks associated with various investment strategies.

Important Takeaways

Management of risk involves identifying as well as analysis and acceptance or reduction of the risk of investment decision making.
Return and risk are inseparable within the world of investment.
There are many ways to determine risk. One of the most popular is the standard deviation, which is an indicator of statistical dispersion around a central tendencies.
Beta, also referred to as risk of market, an indicator of the level of volatility, or risk of an individual stock relation to the market as a whole.
Alpha is a measurement of excessive return; managers who use proactive strategies in order to outperform the market, are vulnerable to the risk of alpha.

What’s Risk Management?

Understanding Risk Management

Risk management is everywhere in finance. It happens when an investor purchases U.S. Treasury bonds over corporate bonds, or when the fund manager hedges his risk of currency exposure by using derivatives of currency, and when a bank conducts an inquiry into the creditworthiness of the person before granting an individual line of credit. Stockbrokers utilize financial instruments, such as futures and options, and money managers utilize strategies like the diversification of portfolios, allocation to assets, and positioning sizing to limit or reduce risk.

Poor risk management can cause severe harm to individuals, businesses as well as the economy. For instance the subprime mortgage meltdown in 2007 which triggered the Great Recession stemmed from bad management of risk, for example the lenders who extended mortgages to those with low credit scores; investment firms that purchased, packaged and then resold these mortgages and funds that made excessive investments in repackaged, yet still risky mortgage-backed securities (MBSs).

Good or Bad, but also necessary Risk

We often imagine “risk” in primarily negative phrases. But in the world of investing it is a necessity and is inseparable from desired performance.

The most common definition of risk in investment is the deviation from the expected outcome. It is possible to define this deviation in absolute terms or as a comparison to something else, for instance, the market benchmark.

Although this deviation can be negative or positive Investment professionals generally agree with the notion that a deviation is a sign of the outcome you want for your investment. In order to get higher returns, one must accept higher risk. It’s also a widely accepted notion that risk increases is a result of higher volatility. Although investment professionals continuously seek – and sometimes find ways to lessen this volatility, there’s no agreement about the best method to achieve this.

How much risk an investor can tolerate is dependent on each risk-averseness of the investor or, for the investment professionals, what tolerance they have for their investment goals. A popular and frequently used risk-based metrics for absolute risk is the standard deviation, which is which is a measure of statistical dispersion of a central trend. When you look at the typical return on an investment, and then determine its average standard deviation for the same time. Normal distributions (the familiar bell-shaped curve) indicate that the expected return of an investment will have a standard deviation below the average of 67 percent of the time, and 2-standard deviations to the mean deviation 95 percent all the time. This allows investors to evaluate the risk in a numerical way. If they believe they can handle the risk financially as well as emotionally, they decide to invest.

Psychological Risk Management as well as Psychology

Although that information can be useful, it will not address all of an investor’s concerns about risk. The area that is known as behavioral finance added significant elements into the overall risk-reward equation, showing the difference in perception between the risk of losing and gains. In the context of prospect theory, which is a branch of finance based on behavioral principles, which was developed by Amos Tversky and Daniel Kahneman in 1979, investors display an aversion to loss. Tversky and Kahneman documented that investors place about twice as much importance on the hurt that comes with losing money than on the pleasure that comes from making a gain.

Most of the time, what investors need to know isn’t how much an investment is off from the expected result and how badly things look to the left-hand side of the curve that is known as distribution. Value at Risk (VAR) seeks to give the answer to this question. The concept behind VAR is to measure the amount of loss on investment is possible with an attainable level of confidence for a specific time.

Of course, even a measurement like VAR does not guarantee that only 5% of the times will be the same as 5. The dramatic failures that struck the hedge fund Long-Term Capital Management in 1998 highlight the possibility that “outlier instances” could occur. In the instance of LTCM an outlier event occurred as a result of an event that resulted in the Russian state’s inability to pay its sovereign obligations. This was which was threatening to ruin the hedge fund that was heavily leveraged positions that were worth more than $1 trillion. If it had been insolvent its own weight, it could have destroyed the financial system worldwide. In the end, however, the U.S. government created a $3.65-billion loan fund to pay for the losses of LTCM, which allowed the company to withstand market’s volatility and liquidate its assets with a controlled manner at the beginning of 2000.