What is risk management?
Looking for a risk management definition? Risk management is the process of identifying potential risks in your investment portfolio, and taking steps to mitigate accordingly. This requires knowledge both of the different types of financial risk, and of the tools that are available to calculate and assess them.
Where have you heard about risk management?
Risk management procedure is an essential part of an investment strategy. Financial advisers talk about risk management with their clients as part of portfolio planning. Corporate investors use analysts and sophisticated modelling to evaluate and manage risk, and their risk management plan will reflect their personal level of risk tolerance or risk aversion. So, risk management goes to the very heart of your investment strategy and will influence the entire plan.
What you need to know about risk management…
To manage risk first you need to work out what you want to gain and what you can afford to lose, and over what timeframe. Then, analyse the variables that might limit your returns or lead to losses, and identify any potential risks in your portfolio. A risk management plan will work out how to mitigate these risks.
Types of risk to manage
As an investor you’ll have to manage many different types of risk, but essentially risk is broken down into two general types: systematic and unsystematic. When we speak about systematic risk we mean uncertainty that prevails across the entire market or a major market segment. Recessions and wars are sources of systematic risk, and it’s very hard to protect against risk of this nature. On the other hand, what’s known as unsystematic risk will only impact on a tiny number of assets. If you hold stocks in a particular auto manufacturer, for example, a sudden outbreak of industrial action at its main UK plant would be an example of unsystematic risk.
Beyond these two main risk categories, there are various other types of risk that could affect particular aspects of your portfolio:
- Country risk – the possibility that a government will be unable to meet its financial obligations. If this happens, bonds, stocks and other financial instruments in that country could be impacted, along with those in other countries it trades with.
- Political risk – the risk of an unexpected change in government policy, for example a move towards stricter regulation, nationalisation or confiscation of assets.
- Foreign exchange risk – the impact of fluctuations in currency exchange rates on the value of an investment or portfolio. If you hold stock in another currency, you could end up losing money if that currency falls in value against your own country’s currency.
- Interest rate risk – the possibility that interest rate changes will impact on the value of an investment, particularly a bond.
- Credit risk – the danger that a business could default on its debt obligations. Investors with corporate bonds in their portfolio have to be wary of this, particularly if they hold what’s known as junk bonds – those that have higher chances of default.
- Market risk or volatility – this is essentially the daily change in share prices. Of course, you need a degree of volatility to make returns.
How to estimate the risks
Investors have lots of tools at their disposal to estimate risks to their portfolio. Here are some of the leading models for risk estimation:
- Alpha and beta. These are risk ratios used to calculate, compare and forecast returns. Alpha is a risk adjusted performance measure that tells investors if they’re being properly compensated for volatility risk they’ve taken. Beta is a historical measure of volatility that gauges how an asset moves against a benchmark such as an index.
- Sharpe ratio. This is the industry standard for calculating risk-adjusted return. In other words, it shows how well the return of an asset compensates an investor for the risk taken. If you compare two assets against the same benchmark, the asset with the higher Sharpe ratio generates a better return for the same risk.
- Capital Asset Pricing Model. This formula calculates the expected return on a security based on its risk level. The CAPM formula is the risk-free rate plus beta of the security times the difference of the expected return on the market and the risk-free rate.
- Value at risk. This estimates how much a portfolio of investments could lose, given normal market conditions, over a certain period such as a day. VaR is generally utilised by firms and financial industry regulators to measure the amount of assets needed to cover potential losses. For instance, if a portfolio of stocks has a one-day 5% VaR of £1 million, that means that a £1 million-plus loss on the portfolio is expected one day out of every 20.
Risk tolerance and risk aversion
As we’ve seen, investors can limit risk by doing research to understand the factors that influence the markets they’re trading on and by carefully monitoring market conditions. But it’s also important for investors to decide how much loss they can afford to take overall and on each trade, and not allow themselves to exceed these limits.
This leads us on to risk tolerance – an important concept in investing. Risk tolerance is the degree of variability in investment returns that an investor is willing to accept. Investors should have a realistic understanding of their ability and willingness to tolerate big swings in the value of their investments. If they take on too much risk, there’s a danger they might panic and sell at the wrong time.
A risk-averse investor dislikes risk, and therefore tends to avoid adding high-risk stocks or investments to their portfolio. But investors with a high level of risk aversion often lose out on more attractive rates of return that less risk-averse investors can potentially enjoy – along, of course, with sharper losses when things go wrong.
How to manage the risks
Developing a robust and effective risk management plan can make all the difference to your success or failure as an investor. As well as informing yourself about all the potential risks, you need to set your own risk limits. Then you can use tools like stop loss orders and limit orders to protect yourself in volatile markets. Stop loss and take profit levels are predetermined price parameters an investor inputs into an order position. They define the trading plan, which helps to trigger an exit strategy when prices move to the desired profitable/loss area.
Diversification is one of several techniques for lowering unsystematic risk as part of a risk management plan. In finance, diversification is the practice of allocating capital in a way that reduces exposure to any one asset or risk. A common diversification strategy is to reduce risk or volatility by investing in a range of different assets. The idea is that if asset prices don’t change in perfect synchrony, a diversified portfolio will have less variance than the weighted average variance of its constituent assets.
A common tactic for managing market risk is to hedge against a variable outcome. For instance, an investor might see if any derivatives are available that would give a return if prices go another way. Or they could adopt a mix of long and short positions.
Investors looking for safer investments often stick to certificates of deposit (CDs), government bonds and Treasury bills (T-bills), which tend to have lower returns. T-bills are seen as very secure, because they’re backed by the full faith and credit of the US government – making them the closest thing to a risk-free return in the market. But investors' overall risk tolerance affects Treasury bill prices. T-bill prices tend to fall when other investments seem less risky and the economy is expanding. On the other hand, during recessions, investors may decide that T-bills are the safest place for their money, and demand can spike.
One more thing – investors are well advised to avoid emotional trading. Research by Barclays Wealth a few years ago calculated that emotional trading can end up costing an investor 20% in returns over a 10-year period. So conduct your technical analysis, set your limits, and stick to a carefully calibrated investment strategy.
Enterprise risk management
If you’re managing risk on behalf of a company, one term you’ll come across is enterprise risk management (ERM). This is the process of planning, organising and controlling an organisation’s activities in order to minimise the effects of risk on the organisation's capital and earnings. Enterprise risk management doesn’t just include the risks connected with accidental losses, but also financial, strategic, operational and other risks.
Enterprise risk management sets out a framework for risk management, which generally involves identifying events or circumstances relevant to the organisation's objectives (risks and opportunities), assessing them in terms of likelihood and size of impact, developing a response strategy, and monitoring progress. By identifying and addressing risks and opportunities, business enterprises can protect and generate value for their stakeholders, including owners, staff, customers and regulators.
Risk management process
Finally, here’s a brief summary of the risk management process. This tends to follow the same basic steps and principles, regardless of the jargon used in individual corporate environments. Together these five steps can produce an effective risk management process:
Step 1: Identify and describe the risks.
Step 2: Analyse the risk, and determine the likelihood and consequence of each risk.
Step 3: Evaluate or rank the risk.
Step 4: Set out a plan to treat or modify the risks to achieve acceptable risk levels.
Step 5: Monitor and review the risk regularly.
Find out more about risk management…
Victor Lipman, an executive coach and author of The Type B Manager, wrote a brief but insightful article entitled ‘All Good Managers Are Risk Managers’. The piece appeared on Forbes.com in October 2017. His key takeaway point: ‘It’s easy to think of risk as a niche issue residing in some distant specialized area. It’s not. It’s everyone’s issue.’