Risk Management

Investors often focus on returns, overlooking risk - the other “R.”

Dec 22, 2022|Education- 5 min

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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

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

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

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

Credit risk is the possibility that an entity is unable to meet its obligations when due.

Legal risk

Legal risk includes the possibility of loss due to a legal action.

Prepayment risk

Prepayment risk is the possibility of reduced returns on bonds or loans due to a borrower prepayment or bonds being called.

Liquidity risk

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:

Understand

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.

Monitor

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.

Measure

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.

Hedging

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.

Conclusion

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.


 

About David M. Darst, CFA

Since January 2017, David M. Darst, CFA has served as Senior Advisor and Investment Strategist of The Family Office in New York and Bahrain. In this role, he has significantly contributed to the formulation, communication, execution, and monitoring of the company’s asset allocation, investment strategy, and wealth management activities in the Gulf region, North America, Europe, and Asia.

Following a 25-year career with Goldman Sachs in Zurich and New York, David served for 17 years as a Managing Director and Chief Investment Strategist of Morgan Stanley Wealth Management. David was the founding President of the Morgan Stanley Investment Group, and has served for three years as CEO of Petiole Asset Management AG, the Zurich-based asset management arm of The Family Office.

David is the author of sixteen books, including The Complete Bond Book (McGraw-Hill), The Handbook of the Bond and Money Markets (McGraw-Hill), The Art of Asset Allocation, Second Edition (McGraw-Hill) and The Little Book that Saves Your Assets (John Wiley & Sons), which has been ranked on the bestseller lists of The New York Times and Bloomberg Business Week.

Disclaimer

This presentation is provided to you by The Family Office Co. BSC(c) (“The Family Office”) for informational purposes only, and contains proprietary information that may not be reproduced, distributed to, or used by, any third parties without The Family Office’s prior written consent.

All information, figures, calculations, graphs and other numerical representations appearing in this presentation have not been audited and may be subject to change over time. Furthermore, certain valuations (including valuations of investments) appearing in this presentation are subject to change as they may be based on either estimates or historical figures that do not reflect the latest valuation. Although all information and opinions expressed in this presentation were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to their accuracy or completeness. The information contained herein is not a substitute for a thorough due diligence investigation. Past performance is not indicative of and does not guarantee future performance. Exit timelines, prices and related projections are estimates only, and exits could happen sooner or later than expected, or at a higher or lower valuation than expected, and are conditional, among other things, on certain assumptions and future performance relating to the financial and operational health of each business and macroeconomic conditions.

The Family Office makes no representation or warranty, express or implied, with respect to any statistics or historical or current financial data, whether created by The Family Office through its own research or quoted from other sources. With respect to any such statistics or data delivered or made available by or on behalf of The Family Office, it is acknowledged that (a) the investor takes full responsibility for making its own evaluation of the materiality of the information and the integrity of the quoted source and (b) the investor has no claim against The Family Office.

Amounts in currencies other than the US Dollar are translated using prevailing market rates as calculated by The Family Office or its service providers and may differ from the rates used by banks. The rates are indicative only and do not reflect the rates at which The Family Office would be prepared to enter into any transactions with other parties.

Certain information contained in this presentation constitutes “forward-looking statements,” which can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “plans,” “estimates,” “intend,” “continue,” or “believe” or the negatives thereof or other variations thereon or comparable terminology. To the extent this presentation contains any forecasts, projections, goals, plans and other forward-looking statements, such forward-looking statements are inherently subject to, known and unknown, significant business, economic, competitive, regulatory and other risks, contingencies and uncertainties, most of which are difficult to predict and many of which are beyond The Family Office’s control and may cause actual performance, financial results and other projections in the future to differ materially from any projections of future performance, results or achievements expressed or implied by such forward-looking statements. Investors should not place undue reliance on these forward-looking statements. The Family Office undertakes no obligation to update any forward-looking statements to conform to actual results or changes in The Family Office’s expectations, unless required by applicable law.

The Family Office makes no representation or warranty, express or implied, with respect to any financial projection or forecast. With respect to any such projection or forecast delivered or made available by or on behalf of The Family office, it is acknowledged that (a) there are uncertainties inherent in attempting to make such projections and forecasts, (b) the investor is familiar with such uncertainties, (c) the investor takes full responsibility for making its own evaluation of the adequacy and accuracy of all such projections and forecasts so furnished to it and (d) the investor has no claim against The Family Office.

This presentation represents a summary of certain information, the full terms of which are contained in a Private Placement Memorandum that should be reviewed for a more complete understanding of the investments and their risks. In addition, this presentation does not constitute an offer to sell, or a solicitation to buy, any instrument or other financial product, nor does it amount to a commitment by The Family Office to make such an offer at present or an indication of The Family Office’s willingness to make such an offer in the future.

The Family Office is a Category 1 Investment Firm regulated by the Central Bank of Bahrain C.R.No.53871 dated 21/6/2004. Paid Up Capital: US$ 10,000,000. The Family Office only offers products and services to ‘accredited investors’ as defined by the Central Bank of Bahrain.


About The Family Office

Since 2004, The Family Office has been the wealth manager of choice for more than 200 ultra-high-net worth families and individuals, helping them preserve and growth their wealth through customized solutions in diversified alternatives and more. Schedule a call with our financial experts and learn more about our wealth management process.

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