What Is Risk Management ?

Risk management involves identifying,  and  accepting or mitigating uncertainty in investment decisions. Put simply, it is the process of monitoring and dealing with the financial risks associated with investing. Risk management essentially occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment, and then takes the appropriate action  to meet their objectives .

• Risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.

• Risk is inseparable from return in the investment world.

• Risk management strategies include avoidance, retention, sharing, transferring, and loss prevention and reduction.

• One of the tactics to ascertain risk is standard deviation, which is a statistical measure of dispersion around a central tendency.

How Risk Management Works

Risk is inseparable from return. Every investment involves some degree of risk. It can come close to zero for U.S. T-bills or very high for emerging-market equities or real estate in highly inflationary markets. Risk is quantified in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs, and costs involved with different investment approaches.

Risk management involves identifying and analyzing where risk exists, and making decisions about how to deal with it. It occurs everywhere in the realm of finance. For instance:

• An investor may choose U.S. Treasury bonds over corporate bonds

• A fund manager may hedge their currency exposure with currency derivatives

• A bank performs a credit check on an individual before issuing a personal line of credit

• A stockbroker uses financial instruments like options and futures

• A money manager uses strategies like portfolio diversification, asset allocation, and position sizing to mitigate or effectively manage risk.

Diligent risk management can help reduce the chance of losses while ensuring that financial goals are met. Inadequate risk management, though, can result in severe consequences for companies, individuals, and the economy. The subprime mortgage meltdown that led to the Great Recession stemmed from bad risk management. Lenders gave mortgages to people with bad credit and investment firms bought, packaged, and resold these loans to investors as risky, mortgage-backed securities .

Risk Management Techniques

The following is a list of some of the most common risk management techniques.

• Avoidance: The most obvious way to manage your risk is by avoiding it completely. Some investors make their investment decisions by cutting out volatility and risk completely. This means choosing the safest assets with little to no risks.

• Retention: This strategy involves accepting any risks that come your way and acknowledging that they come with the territory.

• Sharing: This technique comes with two or more parties taking on an agreed-upon portion of the risk. For instance, reinsurers cover risks that insurance companies can't handle on their own.

• Transferring: Risks can be passed on from one party to another. For instance, health insurance involves passing on the risk of coverage from you to your insurer as long as you keep up with your premiums.

• Loss Prevention and Reduction: Rather than eliminate the potential for risk, this strategy means that you find ways to minimize your losses by preventing them from spreading to other areas. Diversification may be a way for investors to reduce their losses.

The word risk is often thought of negatively. But risk is an integral part of the investment world and is inseparable from performance.

Risk Management and Volatility

Investment risk is the deviation from an expected outcome. This deviation is expressed in absolute terms or relative to something else like a market benchmark. Investment professionals generally accept the idea that the deviation implies some degree of the intended outcome for your investments, whether positive or negative.

To achieve higher returns, one expects to accept the greater risk. It is also a generally accepted idea that increased risk means increased volatility. While investment professionals constantly seek and occasionally find ways to reduce volatility, there is no clear agreement on how to do it.

How much volatility an investor should accept depends entirely on their risk tolerance. For investment professionals, it is based on the tolerance of their investment objectives. One of the most commonly used absolute risk metrics is standard deviation, which is a statistical measure of dispersion around a central tendency.

Here's how it works. Take the average return of an investment and find its average standard deviation over the same time period. Normal distributions (the familiar bell-shaped curve) dictate that the expected return of the investment may be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time. This provides a numeric risk evaluation. If the risk is tolerable (financially and emotionally), they can invest.