Risk Management

Risk Management

In finance, risk management refers to identifying, analyzing, and either accepting or minimizing the effects of uncertainty in investment decision-making. In its most basic form, risk management is the process by which an investor or fund manager examines and makes an effort to estimate the possibility for shortfalls in an investment, such as a moral hazard, and then adopts the appropriate action in light of the fund’s investment goals and its level of risk tolerance.

There is no way to maximize profits without taking some risks. An investment in a U.S. Treasury bill has almost little risk, while investments in developing markets’ stocks or real estate in highly inflationary markets carry extremely high levels of danger. Suppose investors have a firm grasp on the many types of risk they face. In that case, they will have a more nuanced appreciation of various investment strategies’ benefits, drawbacks, and costs.

How to Understand Risk Management?

In the world of finance, risk management is an ever-present reality. It happens when an investor prefers U.S. Treasuries over corporate bonds, when a fund manager uses currency swaps to limit his exposure to foreign exchange fluctuations, and when a bank runs a customer’s credit report before extending a personal loan. Traders use derivatives like options and futures, while portfolio managers employ diversification, investment portfolio, and position sizing methods to control risk.

It’s important for businesses and people to properly manage their risks or face the repercussions, which can devastate their finances and the economy. For instance, lenders who advanced mortgages to people with poor credit; investment companies that purchased, bundled, and resold these mortgages; and financing that invested exceedingly in the repackaged, but still speculative, mortgage-backed securities all contributed to the subprime mortgage meltdown in 2007 that assisted triggering the Great Recession.

Necessary, Good, and Bad Risks

We have the propensity to think about “risk” in mostly pejorative words. However, risk is inevitable in finance and investments and cannot be divorced from good performance.

A popular definition of investment risk is the possibility of a result that differs from anticipated. This divergence can be expressed either in terms of absolute values or values relative to something else, such as a market benchmark.

A positive or negative divergence from the expected value of an investment is nonetheless commonly accepted by the investment community as evidence that the portfolio is performing as intended. The larger the expected return, the more willing one must be to take on risk. Increased volatility is also commonly understood to be a consequence of increased risk. Investment professionals are always looking for—and sometimes finding—new strategies to mitigate this risk, but they can’t seem to agree on the optimal approach.

If you’re an individual investor or an investment professional, the amount of volatility you’re comfortable with is totally up to you and your risk tolerance. The analytical measure of dispersion around a central tendency, standard deviation, is one of the most widely employed absolute risk indicators. The estimated standard deviation of an investment’s return over a certain period can be calculated by first looking at the average return.

Suppose returns follow normal distributions (the bell-shaped curve), then 67% of the time. In that case, they will deviate from the average by just one standard deviation, and 95% of the time, they will deviate by two standard deviations. In a quantitative sense, this aids investors in making informed decisions. People take financial and emotional risks if they can handle the rewards.

Frequently Asked Questions