Risk Management Definition
When used in finance, risk management refers to a set of processes tailored towards the reduction of risks, threats, uncertainties and unfavorable events that can impede the performance of an investment. The major processes in risk management are; identification, evaluation and analysis. Financial advisors, fund managers and general investors often use risk management as a technique to identify and analyze the underlying risks in an investment. Once the risks in an investment are identified, measures are put in place to reduce the impact of the risks so that investment opportunities can be realized. Ways through which risks can be avoided or tolerated are also examined.
A Little More on What is Risk Management
Risk management is an important metric used by businesses, investors, market analysts, fund managers and in the financial world generally. Poor risk management is bad for any business, it amounts to losses and other unfavorable events. In investment, investors effectively use risk management to minimize threats and uncertainties in the investment and maximise losses. Diverse measures of risk management can be used for diverse scenarios, for instance, a fund manager can use portfolio diversification as a risk management approach while a bank checks the credit ratings of customers before issuing them loans.
Poor risk management has been linked to many catastrophic impacts for individual investors, firms and the general economy. The economic meltdown in 208 or the Great Recession are instances of consequences of poor risk management.
In a typical investment, risk is present. The performance of an investment cannot be separated from its underlying risks, in most cases, analysts gauge the performance of investments using the level of risks entailed.
It is also important the risk does not always carry a negative meaning. For instance, when risk is described as a variation from an expected result, the expected result could be good or bad. If the anticipated outcome of an investment is that of losses, and the investment deviates from the expected outcome, the outcome turns out to be good, and vice versa.
How Do Investors Measure Risk?
There are varieties of methods and metrics that can be used to determine risks in investment or financial world. Standard deviation is one of the common techniques that are used for measuring risk. Standard deviation is a statistical measure that reflects the level of divergence of the members of a group from the mean value of the group. The variation or dispersion of a data set is identified through the standard deviation.
For instance, an investor can calculate the average standard deviation of an investment and its average return over a period of time to evaluate the underlying risks of the investment and determined whether the risks can be tolerated or otherwise.
Aside from standard deviation, other metrics for measuring risk include value at risk (VaR), Conditional value at risk (CVaR) and beta.
Risk and Psychology
There is a connection between risk and psychology, this is reflected in the way individuals view profits and losses. The connection between risk and psychology is often studied in behavioral finance, this is however no totally relatedith risks when talking about investments. Amos Tversky and Daniel Kahneman introduced prospect theory in 1979 which is a branch of behavioral finance that studies the deposition of investors to losses and gains. In most cases, investors are fixated on averting losses than celebrating gains.
Oftentimes, investors use Value at Risk (VaR) to evaluate the consequences that will follow the deviation of an esst from its anticipated outcome. How bad the loss associated with a risk is and how things will play put after the loss can be determined through VaR. Investors are able to decide what confidence level to attribute to an investment, for instance, if the confidence level of an investment worth $10,000 is 90%, it means the highest an investor can lose on the investment is $2, 000.
Risk: The Passive and the Active
To identify passive and active risk in an investment, beta is the appropriate metric, beta reflects both active and passive risks. Beta is also known as the market risk, it reflects the risk on investment versus market risk. A beta greater than 1 indicates that the risk of the investment is more than the market risk while a beta less than 1 means the market risk is higher than the investment risk.
The drawdown is another way to measure the risk of an investment which focuses on the period during which the return of an asset is negative as against the previous returns. The drawdown metric evaluates the extent of the negative period or how bad it is, its duration and how often it occurs.
Influence of Other Factors
Aside from the level of risks in the market, there are other factors that influence risk management. Some factors that affect risk management are not related to the market risk like the adjusted-beta market return that directly influence the return of a portfolio. Active fund managers who seek to have returns that supersede the market benchmark use techniques such as fundamental analysis, charting, stock selection, among others to achieve excess market returns.
Alpha is also an important metric that helps to measure excess return on an investment. However, active managers who seek excess returns are often exposed to alpha risk in the sense that their anticipated returns are more negative than positive in most cases.
The Price of Risk
In the investment market, the general rule is that the lower the return of an investment, the lower the risk that investors are exposed to. For active investments that seek excess returns that outperform the market benchmark, investors face higher risks and thereby pay higher exposure fees. Investment instruments such as the U.S Treasury bills and exchange-traded funds (ETFs), investors pay little fees for exposure.
Generally, investments with beta opportunities attract lower fes than investments with alpha opportunities which attract higher fees. The difference in their exposure fees is as a result of the difference in their returns. Alpha investments have returns that outweigh the market return while beta investments stick to returns that align with market benchmark.
The Bottom Line
It is essential to reiterate the relationship between risk and return, one cannot separate return form risk and vice versa. The level of risk in an investment indicates the rate of return that such investment would attract. Risk helps investors understand the underlying opportunities of an investment. Generally, all assets attract a level of risk, in the case of risk-free assets, their risk level is close to zero, example of a risk-free asset is the U.S Treasury Bill. Also, investments with high or excessive returns require that investors pay huge exposure fees to hedge the high degree of risks associated with them.