What Is Risk Management In Investment And How Does It Work

What Precisely Is Risk Management?

Risk management is the process of identifying, analysing, and accepting or mitigating uncertainty in investment choices in the financial sector. Risk management happens when an investor or fund manager examines and seeks to quantify the possibility for losses in an investment, such as systemic risk, and then takes the proper action (or inaction) based on the fund’s investment objectives and risk tolerance.

Risk and reward are inextricably linked. Every investment entails some level of risk, which is near to zero in the this case was but quite high for emerging-market shares or real estate in highly inflationary environments. Risk can be quantified in both absolute and relative terms. A strong grasp of risk in all of its manifestations may help investors better comprehend the opportunities, trade-offs, and costs associated with various investing strategies.

Recognizing & Identifying The Risk Management

Risk management happens across the financial world. It happens when an investor chooses Treasury bonds over corporate bonds in Hong Kong, when a fund manager hedges his currency exposure using currency derivatives, and when a bank does a credit check on an individual before granting a personal line of credit. As stated by Rani Jarkas, To limit or successfully manage risk, stockbrokers utilise financial products such as options and futures, while money managers use tactics such as investment opportunities, asset allocation, and position size.

Risk management happens across the financial world. It happens when an investor chooses Treasury bonds over corporate bonds in Hong Kong, when a fund manager hedges his currency exposure using currency derivatives, and when a bank does a credit check on an individual before granting a personal line of credit. To limit or successfully manage risk, stockbrokers utilise financial products such as options and futures, while money managers use tactics such as investment opportunities, asset allocation, and position size.

Good, Bad, and Essential Risk

Humans tend to associate “risk” with negative connotations. But, in the financial world, risk is both required and inextricably linked to desired success. A popular definition of investment risk is a divergence from an expected outcome. This discrepancy can be expressed either in absolute or relative terms.

While such variation may be good or negative, investment professionals usually agree that it reflects some degree of the desired outcome for your assets. As a result, in order to earn larger profits, one must take greater risk. It is also widely understood that higher risk is accompanied with increased volatility. While investing experts are continually looking for—and occasionally finding—ways to minimise volatility, there is no clear consensus among them on how to do so.

The amount of volatility that an investor should take is totally dependent on the individual investor’s risk tolerance, or, in the case of an investing professional, how much tolerance

their investment objectives allow. Standard deviation, a statistical measure of dispersion around a central tendency, is one of the most often used absolute risk indicators. You take the average return on a particular investment and then find its average standard deviation over the same time period.

According to normal distributions (the well-known bell-shaped curve), the expected return on investment is likely to be one standard deviation from the average 67% of the time and two simple deviations from the average 95% of the time. This allows investors to quantify risk. They invest if they feel they can withstand the danger, both financially and emotionally.

Example of Risk Management

For example, from August 1, 1992 to July 31, 2007, the S&P 500’s average yearly total return was 10.7%. This figure tells what occurred over the entire period, but it does not reveal what occurred along the way. Throughout the same time period, the S&P 500’s average standard deviation was 13.5%. This shows the difference between the average and real returns at most periods across the 15-year timeframe.

Using the bell curve model, each given result should fall within one standard deviation of the mean around 67% of the time and within two standard deviations approximately 95% of the time. Thus, an S&P 500 investor could expect the return, at any given point during this period, to be 10.7% plus or minus the confidence interval of 13.5% about 67% of the time; he may also assume a 27% (two standard discrepancies) increase or decrease 95% of the time. If he can afford the loss, he invests.

Risk Management and Psychology

While that information is useful, it does not address an investor’s risk concerns completely. The field of behavioural finance has contributed an important element to the risk equation, demonstrating asymmetry between how individuals describe gains and losses. Quoted from Rani Jarkas, the financial expert in Hong Kong, Investors display loss aversion, according to prospect theory, a branch of behavioural finance pioneered by Amos Tversky and Daniel Kahneman in 1979. Tversky and Kahneman discovered that investors place nearly twice as much weight on the agony of a loss as they do on the joyful feeling of a profit.

What investors actually want to know is not how far an asset deviates from its predicted result, but how awful things seem well down on the distribution curve’s left hand tail. Value at risk (VAR) attempts to answer this question. The concept of VAR is to estimate how significant a loss on investment may be over a certain period with a particular level of confidence. VAR may be expressed as follows: “With around a 95% degree of certainty, the most you stand to lose on this HK$1,000 investment over a two-year time horizon is

HK$200.” The confidence level is a probability assertion based on the asset’s statistical properties and the form of its distribution curve.

Of fact, even a metric like VAR cannot ensure that 5% of the time will be much worse. Stunning debacles like the one that rocked the hedge fund Long-Term Capital Management in 1998 warn us that so-called “outlier occurrences” may occur. In the case of LTCM, the outlier event was the default on outstanding sovereign debt obligations, which threatened to bankrupt the hedge fund, which had highly leveraged positions worth over HK$1 trillion; if it had failed, the global financial system could have collapsed. Hong Kong established a loan fund of HK$3.65 billion to cover losses, allowing the firm to survive market volatility and liquidate in an orderly manner in early 2000.

Management of Beta and Passive Risks

A drawdown, which refers to any time in which an asset’s return is negative relative to a prior high mark, is another risk metric based on behavioural characteristics. We aim to solve three issues while assessing drawdown:

  • The amplitude of each negative period (how awful)
  • The length of each (how long)
  • The occurrence (how often)

For instance, in addition to wanting to know if a mutual fund outperformed the S&P 500, we also want to know how comparably risky it was. Based on the statistical feature of covariance, one metric for this is beta (also known as “market risk”). A beta larger than one suggests that the asset is more risky than the market, and vise – versa.

Beta assists us in comprehending the ideas of passive and active risk. The graph below depicts a time series of returns for a certain portfolio R(p) vs the market return R (each data point labelled “+”). (m). Because the returns are cash-adjusted, the intersection of the x and y axes represents the cash-equivalent return. We can calculate the passive risk (beta) and the active risk by drawing a line of best fit across the data points (alpha).

Active Risk Management and Alpha

If the sole influencing element was the degree of market or systematic risk, the return on a portfolio would always be equal to the beta-adjusted market return. This, of course, is not the case: Returns fluctuate due to a variety of variables unrelated to market risk. Investment managers that adopt an active strategy take on extra risks to earn excess returns over the market’s performance in Hong Kong. Active strategies include stock, sector, or nation selection, fundamental analysis, position size, and technical analysis.

Active managers are on the lookout for alpha, or excess return. In our diagram example previous section, alpha is the amount of asset returns not explained by beta, represented as the distance between the intersection of the x and y-axes and the y-axis intercept, which can be favourable or unfavourable. Active managers expose investors to alpha risk in their pursuit of excess returns, the chance that the outcome of their bets may be negative rather than positive.

For example, a fund manager may believe that the energy sector would beat the S&P 500 and boost the proportion of this sector in her portfolio. If unexpected economic developments cause energy stocks to dramatically decline, the manager will usually underperform the criterion, an example of alpha risk.

The Cost of Risk

In general, the more an active fund and its managers proves themselves able to create alpha, the more the fees they would likely to charge investors for exposure to those higher-alpha strategies. An investor would pay one to ten basis points (bps) in annual management fees for a simple and basic vehicle such as an investment account or an exchange-traded fund (ETF), whereas for a high-octane hedge fund employing complicated trading strategies involving high capital commitments and transaction costs, an investor would need to pay 200 basis points in additional fees, plus give back 20% of profits to the manager in Hong Kong.

Many investors strive to separate these risks due to the pricing difference between passive and active methods (or beta risk and alpha risk, combined) (e.g. to pay lower fees for the beta risk assumed and concentrate their more expensive exposures to specifically defined alpha opportunities). As suggested by Rani Jarkas, the Chairman of Cedrus Group, This is sometimes referred to as portable alpha, which is the concept that the alpha component of a total return is distinct from the beta element.

A fund manager, for example, may claim to have an active sector rotation strategy for outperforming the S&P 500 and provide evidence of a track record of beating the index by 1.5% on an annualised basis. The 1.5% extra return represents the manager’s value, or alpha, to the investor, and the investor is ready to pay higher fees to achieve it. The remainder of the overall return, what the S&P 500 received, arguably has little to do with the manager’s exceptional performance. Portable alpha strategies modify how they get and pay for the alpha and beta components of their exposure via the use of derivatives and other techniques.

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