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Understanding Risk Management

In the financial sector risk management refers to the identifying of, analysis, and acceptance or reduction of uncertainty when making the investment decision-making process. In essence, risk management happens when an investor or fund manager considers and attempts to assess the possibility of losing money from an investment like moral hazard, and decides on the best course of step (or decision) in accordance with the investment objectives of the fund as well as tolerance to risk.

Risk is inseparable from returns. Every investment comes with a degree of risk. This 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 as well as relation to. An understanding of risk’s various forms can assist investors better know the trade-offs, opportunities and the costs associated with various investment strategies.

Important Takeaways

The process is called risk management. It involves the identifying of, analysis, and acceptance or reduction of the risk of investment decision making.
Risk is interconnected with return within the world of investment.
There are many ways to determine risk. One of the most popular is the standard deviation, which is a measure 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 a particular stock in contrast to the whole market.
Alpha is a measurement of excessive return; managers who use proactive strategies in order to outperform the market, are exposed to the risk of alpha.

What exactly is Risk Management?

Understanding Risk Management

Risk management can be found all over finance. It is 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 for currency, or when a bank conducts a credit screening on an individual prior to granting an individual line of credit. Stockbrokers make use of 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 have dire consequences for businesses, individuals as well as the economy. As an example the subprime mortgage meltdown in 2007 which triggered the Great Recession stemmed from bad decision-making regarding risk management, including lenders who offered mortgages to people with weak credit, investment companies that purchased, packaged, and resold these mortgages and funds that made excessive investments in repackaged, yet still risky mortgage-backed securities (MBSs).

Good as well as bad, and a necessity Risk

We often imagine “risk” as primarily negative in terms of negative. But in the world of investment the risk factor is essential and is inseparable from desired performance.

A standard definition of risk in investment is the deviation from the expected outcome. This deviation can be expressed in absolute terms, or in relation to another thing, such as the market benchmark.

Although this deviation can be negative or positive experts in investment generally agree the concept that any deviation is a sign of the outcome you want for your investment. Therefore, to earn higher returns one must accept higher risk. It’s also a widely accepted notion that risk increases results in greater volatility. Investment professionals are constantly looking for — and sometimes find ways to lessen this volatility, there’s no consensus among them about the best method to achieve this.

The amount of volatility an investor can tolerate is entirely dependent on the risk-averseness of the investor or, for the investment professionals, the amount of tolerance their goals for investing allow. A popular and widely utilized absolute risk metrics is the standard deviation, which is which is a measure of statistical dispersion in the direction of a central tendency. It is possible to look at the average 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 standard deviation 95 percent times. This allows investors to evaluate the risk mathematically. If they believe they are able to handle the risk financially and emotionally, they decide to invest.

Psychological Risk Management as well as Psychology

Although this information could provide valuable information, it does not completely address the investor’s risks. The area of behavioral finance provided an important component into the overall risk-reward equation, showing the difference in perception between profits and losses. In the context of prospect theory, which is a branch of behavioral finance that was first introduced by Amos Tversky and Daniel Kahneman in 1979, investors show an aversion to loss. Tversky and Kahneman documented that investors place roughly double the importance on the hurt that comes with losses than the satisfaction that comes with the feeling of a gain.

Oft, what investors need to know isn’t the extent to which an asset is out of line with the outcome they expected however, how dire things appear to the left-hand side of the curve that is known as distribution. Value at Risk (VAR) is a method to provide an answer to this issue. The purpose of VAR is to measure the extent of loss that an investment can be at the same level of certainty over a specified time.

Of of course, a statistic such as VAR can’t ensure that only 5% of the times will be the same as 5. Dramatic failures like the one that afflicted the hedge fund Long-Term Capital Management in 1998 highlight the possibility that “outlier instances” can occur. In the instance of LTCM an outlier event is an event that resulted in the Russian Government’s failure to meet its obligations on outstanding sovereign bonds. This was the event was likely to ruin the hedge fund with highly leveraged investments worth nearly $1 trillion. If the hedge fund had failed the pressure of default, it would have sunk the financial system of the world. In the end, however, the U.S. government created a $3.65-billion loan fund to pay for the losses of LTCM. This allowed the company to withstand market’s volatility and liquidate its assets efficiently at the beginning of 2000.