What is Risk Management?
In the financial world, risk management is the process of identifying, analyzing, accepting or mitigating uncertainties in investment decisions. Essentially, risk management occurs when an investor or fund manager attempts to analyze and quantify the likelihood of losses in an investment, such as moral hazard.
Risk is inseparable from income. All investments involve some level of risk, which is considered close to zero for U.S. government bonds or very high for things like emerging market stocks or real estate in a market with high inflation. Risk can be quantified in both absolute and relative terms. A clear understanding of different forms of risk can help investors better understand the opportunities, trade-offs and costs associated with different investment approaches.
Understanding Risk Management
Risk management happens everywhere in finance. It happens when investors buy U.S. Treasuries rather than corporate bonds, when fund managers hedge currency risk with foreign exchange derivatives, and when banks check the creditworthiness of individuals before issuing personal credit limits. Exchange brokers use financial products such as options and futures, and financial managers use strategies such as portfolio diversification, asset allocation and position sizing to reduce or effectively manage risk.
Improper risk management can have serious consequences for businesses, individuals and the economy. For example, the collapse of low-quality mortgages in 2007, which triggered the economic downturn, was the result of poor risk management decisions, such as borrowers who provided mortgages to individuals with bad credit, investment firms that bought, packaged and resold these mortgages, and funds that overvalued investments in over-packaged but still dangerously over-packaged MIs.Mortgage Securities (MBS)
How Risk Management Works
We tend to think of “risk” primarily as a negative term. However, in the investment world, risk is inseparable from necessary and desirable outcomes.
A common definition of investment risk is a deviation from expected outcomes. We can express this deviation relative to other measures, such as absolute performance or market benchmarks.
These deviations can be positive or negative, but investment experts generally agree on the idea that these deviations mean some degree of expected outcome for your investment. Therefore, in order to get a higher return, you need to take more risk. It is also generally accepted that increased risk manifests itself in the form of increased volatility. Investment experts are constantly looking, and sometimes looking, for ways to reduce this volatility. However, there is no clear consensus among investment professionals on how best to deal with this volatility.
The degree of volatility an investor should accept depends entirely on the individual investor’s tolerance for risk or, in the case of an investment professional, how acceptable the investment objective is. One of the most commonly used measures of absolute risk is Standard Deviation, a statistical measure that measures the spread around a central trend. Examine the average return on your investment and then find the average standard deviation over the same period. A normal distribution (the familiar bell-shaped curve) indicates that investment returns are likely to be 1 standard deviation at 67% average and 2 standard deviations at 95% average. This helps investors assess risk numerically. Invest if you believe you can risk economically and emotionally.
For example, from August 1, 1992 to July 31, 2007, the S&P 500 had an average annual compound return of 10.7% over 15 years. This number shows what happened during the entire period, but it doesn’t tell you what happened during the process. The average standard deviation of the S&P 500 index over the same period was 13.5%. This is the difference between the average return and the actual return at most given points over the 15-year period.
When applying the bell curve model, the result obtained should refer to two standard deviations: about 67% of the average and about 95%. Thus, S &P 500 investors can expect a standard deviation of 10.7% plus or minus 13.5% at any point in the period of about 67%. If he can afford to lose, he invests.
Risk Management and Psychology
Such information can be useful, but it does not fully address investors’ concerns about risk. The field of behavioral finance has introduced an important factor into the risk equation by showing the asymmetry between how people view profits and losses. In the language of prospect theory, the field of behavioral finance introduced by Amos Tversky and Daniel Kahnerman in 1979, investors have an aversion to losses. Tversky and Kahneman documented that investors paid about twice as much attention to the pain caused by losses as to the mood caused by gains.
Often investors really want to know not only how much an asset deviates from expected performance, but also how bad things are on the left end of the distribution curve. Value at Risk(VAR) attempts to answer this question. The idea behind VAR is to quantify how big an investment’s losses can be at a given confidence level over a given period of time.
Beta and Passive Risk Management
Another measure of risk focused on behavioral trends is drawdown, which refers to the period when asset returns are negative relative to past peaks. When measuring drawdowns, we try to consider three things:
The size of each negative period (bad).
Each period (time).
For example, not only do we want to know whether an S & P 500 mutual fund won or lost, but we also want to know how risky it was relatively. One measure of this is the beta (“market risk”), which is based on the statistical nature of covariance. If the beta is greater than 1, it represents more risk than the market, and vice versa.
Beta helps us understand the concept of passive and active risk. The graph below shows the time series (“+”) for a particular portfolio R(p) as a function of market returns R (m). The returns are adjusted for cash, so the intersection point of the x and y axes is the cash-equivalent return. By drawing the optimal fit lines through the data points, we can quantify passive risk (beta) and active risk (alpha).
The slope of the line is equal to beta. For example, a slope of 1.0 indicates that for every unit of market return increases, portfolio income also increases by one unit. A fund manager employing a passive management strategy can increase portfolio returns by taking on more market risk (i.e., a beta greater than 1), or reduce portfolio risk by lowering portfolio beta (and income) below 1.
Alpha and Active Risk Management
If only market level or systemic risk is affected, portfolio returns will always be the same as beta-adjusted market returns. Of course not. Returns vary depending on a number of factors independent of market risk. Investment managers who pursue an active strategy take a variety of risks in order to make super profits compared to market performance. Active strategies include tactics using stock, sector or country selection, basic analysis, position size and technical analysis.
Active managers look for Alpha, an indicator of excess returns. In the chart example above, alpha is the value of portfolio returns not described in beta, expressed as the distance between the x-axis intersection and the y-axis intersection, and can be positive or negative. In the pursuit of super profits, active managers expose investors to alpha risk, which is the risk that their betting results will be negative rather than positive. For example, fund managers may think that the energy sector will outperform the S&P 500 Index and increase the weighting of their portfolios in that sector. If energy stocks fall because of unexpected economic developments, managers are likely to fall below the benchmark, which is an example of alpha risk.
In general, the more active funds and their managers demonstrate the ability to create alpha strategies, the higher fees they tend to charge investors for using higher alpha strategies. For purely passive instruments such as index funds or exchange-traded funds (ETFs), investors will likely pay 1 to 10 basis points (bps) in annual management fees, while for high-octane hedge funds that use sophisticated trading strategies involving high capital commitments and transaction costs, investors will have to pay 200 basis points in annual fees. And returns 20% of profits to the manager.
The price differential between passive and active strategies (or beta and alpha risks) encourages many investors to share these risks (e.g., pay lower fees for perceived beta risks and focus more expensive risks on specifically defined alpha opportunities). This is commonly known as portable alpha, which is when the alpha component of total return is separated from the beta component.
For example, a fund manager may claim to have an active sector cyclical strategy to outperform the S & P 500 Index, which may show an annual average return of 1.5% over the index. For investors, the excess return of 1.5% is the value of the manager, that is alpha, and the investor is willing to pay a higher fee to get it. The rest of the total return, i.e., the return generated by the S &P 500 itself, may not be related to the unique abilities of the director. The portable alpha strategy uses derivatives and other tools to improve how you get and pay for the alpha and beta components of your risk.