Risk Management in Finance

In the financial world, risk management is the process of

identification, analysis and acceptance or mitigation of uncertainty in investment
decisions. Essentially, risk management occurs when an investor or fund
manager analyzes and attempts to quantify the potential for losses in an
investment and then takes the appropriate action (or inaction) given his
investment objectives and risk tolerance.
What is Risk Management?
What is Risk Management?
Risk management occurs everywhere in the financial world. It occurs when an investor buys
low-risk government bonds over riskier corporate bonds, when a fund manager hedges his
currency exposure with currency derivatives, and when a bank performs a credit check on an
individual before issuing a personal line of credit. Stockbrokers use financial instruments
like options and futures, and money managers use strategies like portfolio and investment
diversification to mitigate or effectively manage risk.

Inadequate risk management can result in severe consequences for companies, individuals, and
the economy. For example, the subprime mortgage meltdown in 2007 that helped trigger the
Great Recession stemmed from poor risk-management decisions, such as lenders who extended
mortgages to individuals with poor credit, investment firms who bought, packaged, and resold
these mortgages, and funds that invested excessively in the repackaged, but still risky, mortgage-
backed securities (MBS).

The Good, the Bad, and the Necessary

We tend to think of "risk" in predominantly negative terms. However, in the investment world,
the risk is necessary and inseparable from the performance.

A common definition of investment risk is a deviation from an expected outcome. We can

express this in absolute terms or relative to something else, like a market benchmark. That
deviation can be positive or negative, and it relates to the idea of "no pain, no gain" (to achieve
higher returns, in the long run, you have to accept the more short-term risk, in the shape
of volatility).

How much volatility depends on your risk tolerance, which is an expression of the capacity to
assume volatility based on specific financial circumstances and the propensity to do so, taking
into account your psychological comfort with uncertainty and the possibility of incurring large
short-term losses.

How Investors Measure Risk

Investors use a variety of tactics to ascertain risk. One of the most commonly used absolute risk
metrics is standard deviation, a statistical measure of dispersion around a central tendency. You
look at the average return of an investment and then find its average standard deviation over the
same time period. Normal distributions (the familiar bell-shaped curve) dictate that the expected
return of the investment is likely to be one standard deviation from the average 67% of the time
and two standard deviations from the average deviation 95% of the time. This helps investors
evaluate risk numerically. If they believe that they can tolerate the risk, financially and
emotionally, they invest.

For example, during a 15-year period from August 1, 1992, to July 31, 2007, the
average annualized total return of the S&P 500 was 10.7%. This number reveals what happened
for the whole period, but it does not say what happened along the way. The average standard
deviation of the S&P 500 for that same period was 13.5%. This is the difference between the
average return and the real return at most given points throughout the 15-year period.

When applying the bell curve model, any given outcome should fall within one standard
deviation of the mean about 67% of the time and within two standard deviations about 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 standard deviation of 13.5% about 67% of the time; he
may also assume a 27% (two standard deviations) increase or decrease 95% of the time. If he can
afford the loss, he invests.

Risk and Psychology

While that information may be helpful, it does not fully address an investor's risk concerns. The
field of behavioral finance has contributed an important element to the risk equation,
demonstrating asymmetry between how people view gains and losses. In the language
of prospect theory, an area of behavioral finance introduced by Amos Tversky and Daniel
Kahneman in 1979, investors exhibit loss aversion: they put more weight on the pain associated
with a loss than the good feeling associated with a profit.

Often, what investors really want to know is not just how much an asset deviates from its
expected outcome, but how bad things look way down on the left-hand tail of the distribution
curve. Value at risk (VAR) attempts to provide an answer to this question. The idea behind VAR
is to quantify how bad a loss on investment could be with a given level of confidence over a
defined period. For example, the following statement would be an example of VAR: "With about
a 95% level of confidence, the most you stand to lose on this $1,000 investment over a two-
year time horizon is $200." The confidence level is a probability statement based on the
statistical characteristics of the investment and the shape of its distribution curve.

Of course, even a measure like VAR doesn't guarantee that 5% of the time will be much worse.
Spectacular debacles like that of the hedge fund Long-Term Capital Management in 1998 remind
us that so-called "outlier events" may occur. In the case of LTCM, the outlier event was the
Russian government's default on its outstanding sovereign debt obligations, an event that
threatened to bankrupt the hedge fund, which had highly leveraged positions worth over $1
trillion; if it had gone under, it could have collapsed the global financial system.

Passive vs. Active Risk

Another risk measure oriented to behavioral tendencies is a drawdown, which refers to any
period during which an asset's return is negative relative to a previous high mark. In measuring
drawdown, we attempt to address three things: the magnitude of each negative period (how bad),
the duration of each (how long), and the frequency (how often).

For example, in addition to wanting to know whether a mutual fund beat the S&P 500, we also
want to know how comparatively risky it was. One measure for this is beta (known as "market
risk"), based on the statistical property of covariance. A beta greater than 1 indicates more risk
than the market and vice versa.

Beta helps us to understand the concepts of passive and active risk. The graph below shows
a time series of returns (each data point labeled "+") for a particular portfolio R(p) versus the
market return R(m). The returns are cash-adjusted, so the point at which the x and y-axes
intersect is the cash-equivalent return. Drawing a line of best fit through the data points allows us
to quantify the passive risk (beta) and the active risk (alpha).

The gradient of the line is its beta. For example, a gradient of 1.0 indicates that for every unit
increase of market return, the portfolio return also increases by one unit. A manager employing a
passive management strategy can attempt to increase the portfolio return by taking on more
market risk (i.e... a beta greater than 1) or alternatively decrease portfolio risk (and return) by
reducing the portfolio beta below 1.

Influence of Other Factors

If the level of market or systematic risk were the only influencing factor, then a portfolio's return
would always be equal to the beta-adjusted market return. Of course, this is not the case as
returns vary because of a number of factors unrelated to market risk. Investment managers who
follow an active strategy take on other risks to achieve excess returns over the market's
performance. Active strategies include stock, sector or country selection, fundamental analysis,
and charting.

Active managers are on the hunt for an alpha, the measure of excess return. In our diagram
example above, alpha is the amount of portfolio return 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
positive or negative. In their quest for excess returns, active managers expose investors to alpha
risk, the risk that the result of their bets will prove negative rather than positive. For example, a
manager may think that the energy sector will outperform the S&P 500 and increase her
portfolio's weighting in this sector. If unexpected economic developments cause energy stocks to
sharply decline, the manager will likely underperform the benchmark, an example of alpha risk.

The Cost of Risk

In general, the more active the investment strategy (the more alpha a fund manager seeks to
generate), the more an investor will need to pay for exposure to that strategy. For a purely
passive vehicle like an index fund or an exchange-traded fund (ETF), you might pay 15-20 basis
points in annual management fees, while for a high-octane hedge fund employing complex
trading strategies involving high capital commitments and transaction costs, an investor would
need to pay 200 basis points in annual fees, plus give back 20% of the profits to the manager.
The difference in pricing between passive and active strategies (or beta risk and alpha risk
respectively) encourages many investors to try and separate these risks (e.g. to pay lower fees for
the beta risk assumed and concentrate their more expensive exposures to specifically defined
alpha opportunities). This is popularly known as portable alpha, the idea that the alpha
component of a total return is separate from the beta component.

For example, a fund manager may claim to have an active sector rotation strategy for beating the
S&P 500 and show, as evidence, a track record of beating the index by 1.5% on an average
annualized basis. To the investor, that 1.5% of excess return is the manager's value, the alpha,
and the investor is willing to pay higher fees to obtain it. The rest of the total return, what the
S&P 500 itself earned, arguably has nothing to do with the manager's unique ability. Portable
alpha strategies use derivatives and other tools to refine how they obtain and pay for the alpha
and beta components of their exposure.

The Bottom Line

Risk is inseparable from return. Every investment involves some degree of risk, which can be
very close to zero in the case of a U.S. Treasury security or very high for something such as
concentrated exposure to Sri Lankan equities or real estate in Argentina. Risk is quantifiable both
in absolute and in relative terms. A solid understanding of risk in its different forms can help
investors to better understand the opportunities, trade-offs, and costs involved with different
investment approaches.

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