Investors often focus on returns, overlooking risk--the other “R.”
Investments that promise ultra-high returns tend to be riskier, leading to losses that may exceed your risk tolerance. Risk management is key to portfolio management. Your goal as an investor should be to manage risk prudently and not eliminate it entirely.
What do we mean by risk?
Risk is about uncertainty. The higher the risk, the lower the certainty of the promised return.
Government bonds denominated in its domestic currency are often considered “risk-free.” The promised coupon payment is practically 100% guaranteed as the issuing government can simply print the money to meet its obligations.
On the other end of the risk spectrum is for example a technology start-up raising capital. If it becomes the next Facebook, the returns could be exponential, but the likelihood of a loss is very high.
Types of risk
Risks fall into many categories and the below are by no means comprehensive. Some risks affect the entire market.
- Market risk is the possibility of loss due to factors that affect the performance of financial markets, such as a drop in investor confidence.
- Interest rate risk is the possibility that a change in interest rates would reduce the value of bonds or other fixed-rate investments.
- Event risk is the possibility of loss due to unforeseen occurrences such as war or natural disasters.
Other risks are specific to a firm, sector, or product.
- Credit risk is the possibility that an entity is unable to meet its obligations when due.
- Legal risk includes the possibility of loss due to a legal action.
- Prepayment risk is the possibility of reduced returns on bonds or loans due to a borrower prepayment or bonds being called.
- Liquidity risk includes the possibility of loss arising from a distress sale of an asset when there are not enough buyers.
The list of risks is indefinite, and the risk factors depend on your exposure to specific industries, companies, products, and geographies.
The four elements of risk management
While risk management is a complex task, it consists of four basic steps:
The first step in risk management is understanding the risks—external and internal—to which your investment portfolio is exposed. Some risks apply to all investors, while others relate to where your capital is deployed. It is also important to understand the investor risk tolerance level (i.e., willingness and ability to take risk) and manage the portfolio accordingly.
The next step is to identify the data pertaining to the key sources of risk. This could be publicly available economic data or a private database by a commercial enterprise. Some data may need to be estimated based on expert opinion.
The data must be synthesized to give an ongoing, quantitative assessment of how key risks in a portfolio are developing, and whether they are within acceptable limits. This may include calculating and updating prices for illiquid assets where the market price is not available. The estimated risk level should be measured against the investor risk appetite and rebalancing might be necessary when this is exceeded.
Certain risks can be reduced through hedging instruments (e.g., covering a long position with a short position, buying put options to limit the downside of holding a stock, converting a floating rate loan to fixed rate loan through an interest rate swap, using currency options and forwards to mitigate exposure to foreign currencies, etc.). However, the cost of hedging may reduce returns and the risk manager must evaluate an optimal strategy carefully.
Risk is unavoidable and inextricably linked to return. Seeking only “safe” investments to minimize risk may not create sufficient returns to meet your goals. Risk management is about optimizing risk and return within the risk tolerance. Having a professional wealth manager that optimizes your risk-adjusted return is clearly an advantage.
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