In finance, risk management is an activity conducted to analyze, identify and afterward accept or mitigate the uncertainties that come inseparably with investments. The key task of risk management is to analyze the investment decision and attempt to quantify the potential losses. After that, the investor can take appropriate action or stay passive based on the investment objectives.
Return and risk cannot be separated. The higher risk level can be for example seen when investing in real estate in highly inflationary markets or emerging-market equity. By the way, we can quantify risk both as an absolute or a relative value. Overall, investors become capable of understanding the opportunities, the costs, and the trade-offs once they have a proper understanding of risk.
Risk management explanation
The world of finance is full of risks. Thus, every activity then is accompanied by risk management. It occurs when money managers choose portfolio diversification strategies when banks perform credit checks prior to issuing a credit when stockbrokers use different financial instruments such as futures or options. In all these and many other cases, risk management is aimed at handling a risk effectively.
When risk management is performed inadequately, the situation can become dangerous for those engaged in it whether it comes to companies, economies, or individuals. As an example, we can take the subprime meltdown of 2007 which put the start to the Global Recession. This situation was a result of bad risk management.
As human beings, we have a tendency to look at risk from a negative point of view. Yet in the field of investments, the desired performance is always out of reach if one is not prepared to take a risk. The general meaning of risk is any kind of deviation from what is expected. This deviation can be represented by a relative value or an absolute number.
Although the deviation could be positive or negative, most investing experts agree that it means a degree of the desired result for the investments. Therefore, it is generally accepted that higher returns are connected with higher risks that in their turn come within increased volatility. Every investor accepts different levels of volatility based on their risk tolerance and investment objectives.
Standard deviation belongs among the most common absolute risk metrics and expresses a statistical measure of dispersion around a central tendency. It is calculated by looking at the average investment return and finding its average standard deviation after the same time period. This metric is important because it enables investors to quantify the risk numerically. At last, if the investors decide that they tolerate the evaluated risk, they invest.
Another metric is focused on behavioral tendencies and aims at measuring a drawdown which can be defined as a period when an asset’s return tends to be lower compared to the previous level. When a drawdown is measured, investors should pay attention to:
- How bad the negative period is;
- How long it lasts for;
- How often such periods take place.
This metric is called beta. It helps measure the volatility on the market or systemic risk of a certain stock in relation to the whole market.
However, market or systematic risks are not the only factors that impact a portfolio’s return. Returns are additionally influenced by many other factors, not related to market risk, so it is not enough to adjust the returns by the beta results. Some investors employ active strategies seeking excess returns. Going for excess returns, managers become exposed to alpha risks. That said, alpha can be defined as a measure of excess return.
It is useful to seek assistance while conducting highly important investment decisions. COREDO experts are here to perform risk management activities for you.