Risk Management

Risk management is world-widely known as a process in which uncertainty in investment decisions are being determined, thoroughly analyzed and accepted as something inevitable. It also determines what means may be taken in order to mitigate the collateral risks. In most cases, risk management takes place at the moment an investor or manager of a fund carries an analysis out in order to estimate how many losses this investor or this fund may incur as the result of a particular investment. For example, during the estimation a moral hazard may be taken into account. Then, a decision to invest or not to invest is taken, considering the investor and the fund investment objectives and risk tolerance.

Where Risk Management is needed

Investors are involved in risky activities all the time. Thus, risk management is also needed everywhere. For example, an investor assesses that government bonds are rather safe and he or she chooses government bonds over corporate ones. In case a bank looks into a person's credit history before giving him or her a loan, it also may be regarded as a risk management.

Returns can’t exist without risks. Especially large returns involve large risks. Generally, there is no investment without a certain risk degree. The risk degree can be around zero in case of investing in government debt obligations (they are considered the safest in many countries), the risk degree can be exceedingly high, in case an investment is made in a market that is susceptible to inflation. Risk may be estimated in absolute terms as well as in relative terms. Different methods for risk management and form of risks may help investors to understand what opportunities the market gives.

Risk management has different tools. For instance, there are stockbrokers who utilize options and futures. Money managers use different kinds of instruments in order to handle risks in the best possible way. They use portfolio diversification, position sizing, etc.

However, risk management is engaged with its own risks. Poor risk management may lead to dreadful outcomes, which would have a severe impact on individuals, people, different organizations and the whole economy. For example, giving loans to the people with poor or bad credit history may cause terrible events, such as economic recessions, etc.

Main principles of Risk Management

Usually, the word risk has a negative connotation, since risks are unpredictable and connected to danger and harm. Nevertheless, the realm of investment doesn’t consider only negative ways. For investment, risk is the essential part without which, it’s to achieve the goal an investor desires. One of the most popular definitions of the risk that an investment involves is a deviation from an expected outcome. Thus, there is no negative sense, the term refers to any changes in expectations, not necessarily to the negative changes.

Experts in the investment field accept the existence of any outcome of risk, both positive and negative. Since any investment implies risk, it’s believed that the greater risk is, the higher returns will be. Thus, an investor while investing should always keep in mind the general idea of the risk existence. Moreover, it’s said that high risks in investments are conveyed in high volatility. Many experts desperately try to find the best way to handle it. However, they are still too far from the end of their search.

Almost every investment is connected with volatility.Thus, every investor accepts the level of volatility according to his or her risk tolerance. In case an investor is a kind of professional, he or she acts according to the objectives that investments have. There are several metrics with help of which investors may put investment risks in numbers and estimate whether each risk taken is worth or not. Among these metrics, standard deviation is distinguished. Standard deviation is regarded as an absolute risk metric.

In order to calculate, you need to take an investment return, estimate its average number and then to calculate its standard deviation (average as well) within the same time interval. There are accepted norms, which say that normally from the average 67 percent the expected return equals one standard deviation, while from the average deviation 95 percent the expected return equals two standard deviations. Thus, in case an investor is self-confident and sure that he or she is able to handle the risk in every aspect, then the investor is eager to invest.

Example of Risk Management

All developed companies have their own risk management program. There can be an inner team inside the company, or the company may attract people who are specialized in creating risk management plans. For example, Samsung divides all risks it may incur in three types: market, credit and liquidity. The Board of Directors is the first who responds to the risk-related issues. Then, Samsung has the Risk Management Executive Committee, which is in charge of decisions in sales secrets. Risk management must be independent, in order to provide it, the company doesn’t allow the head of the trading division to take the role of the head of the risk management division or to become the executive officer. The person who ensures independence of the process is the chief risk officer.

Psychology in Risk Management

This piece of information may seem irrelevant to the current topic. However, it can become helpful for some investors. The study named behavioral finance became an important component of the risk equation. The equation explained that people perceive gains and losses in extremely different ways. The study was presented a little more than 40 years ago, and it showed that investors were prone to experience loss aversion. It was proved that investors feel the pain from a loss twice harder, than the joy of getting a profit.

The study also showed that investors desire to know two things. The first is the expected outcome, i.e. how much money they get. The second thing is more desired, and it’s the state of things on the left tail of the distribution curve. It may become clearer with the help of value at risk (i.e. VAR). This means takes one particular period of time and tries to measure the potential losses of an investment according to the confidence level. Basically, the confidence level is a probability statement. It may be identified by the statistical characteristics of an investment and the shape of an investment distribution curve. However, an investor should always remember that VAR can’t guarantee anything, it’s only a tool, which can help.

Other measures used in Risk Management

There are other different measures that are based on behavioral studies, For example, one of them is called drawdown. It refers to the periods within which an asset profit is negative in comparison to the previous. While measuring it, three aspects become important. The first aspect is how bad the asset felt during every period that is considered negative. The second aspect is how long the period lasts, i.e. duration itself. The last is with what frequency these periods happen.

Another measure is called beta (also known as market risk). This measure is used when an investor is interested in an asset and wants to know how risky the investment in it was. It’s based mostly on the statistical property of covariance. In case a beta is bigger than one, it refers to the situations in which the risk is higher.