“I think the best investment advice I ever received was that any investment process should begin, not end with risk management”.
John Butler on the Hive Podcast Ep. 68.
Every single investment carries risk. Even US treasuries, thought of as the safest of all investments, have a slight risk of government default. But by consciously managing financial risk, it is possible to mitigate many adverse outcomes and create a balanced portfolio that generates returns.
Here, we take a look at the fundamentals of risk management and the role it can play in your investment process.
What Is Risk Management?
Risk management is a continuous process, and investors need to make sure that they constantly monitor their portfolios to identify all the relevant threats. Of course, it is impossible to completely eliminate risk, but investors try to limit risk as much as they can according to their risk tolerance.
For an investor, risk management involves the identification and mitigation of uncertainty in the investment strategy. Once the relevant factors have been identified, the investor then takes steps to make sure that their impact is limited.
Why Is the Risk Management Process Important?
Only by taking on risk is it possible to generate returns; it is impossible to separate them. Consequently, learning to assess and mitigate risk is a critical skill for an investor of any level.
A lot of risk is often already priced into an asset, negatively or positively affecting its price. However, the perceived risk of any asset is not always accurate. Many investments that are deemed risky may actually be a lot safer in reality, and vice versa.
Nowhere has this been more evident than in the Global Financial Crisis. Many people thought subprime mortgages were relatively safe investments. In the simplest of terms, this is because once the bonds were considered diversified enough, credit rating agencies were willing to give them a higher rating. In reality, the bonds were a lot riskier, and those who managed to foresee this profited from the crisis massively.
There are certain risks that are preventable. In the case of a stock, preventable risks might be the kinds of risks that do not generate any strategic benefit to the company but may cause it to experience material loss.
Rick Seeger described it quite well when he mentioned in Ep.94 of the Hive Podcast, ‘Take risks, but have defined risk quotients… Simply put, take risks, know what you can afford to lose and know where you can go with it. Some of the best things in investing comes from taking some of the biggest risks.’
The risk management process is important because if you only invest in the best low risk investments, you will almost certainly underperform the market over the long run. This is evident once you compare the returns of S&P 500 to US Treasury Bills. $100 invested in the former in 1928 would be worth $624,534 as of 2022, whereas T-Bills would be worth only $2,140. Ideally, you want to have both low and high risk investments in your portfolio, paying special attention to your risk profile in the process.
Types of Risk in Investments
There are many types of risks that you will need to watch out for. Here, we talk about the main categories of risk impacting both low risk and high risk investments.
Types Of Risks Impacting Investments
|Default Risk||This is the chance that a company will not be able to meet its obligation to make interest payments on its loans.|
|Currency Risk||Currency risk applies to foreign currencies that a company may have exposure to. For example, a US-based company may experience a decline in revenue if its primary customers are in the European Union and the Euro takes a sudden dive.|
|Interest Rate Risk||This primarily applies to bonds and other low risk investments. Changes in interest rates can impact the price of the asset in both negative and positive ways.|
|Liquidity Risk||Liquidity risk relates to the difficulty of buying and selling an asset quickly. For example, large-cap stocks listed on a major exchange are usually considered extremely liquid, while real estate is considered to be a fairly illiquid asset.|
|Political/Legal Risk||The extent to which an investment may be impacted by political decisions in the country and around the globe. The best example of this is how UK equities underperformed for a number of years following the Brexit referendum in 2016.|
It is important to remember that the aforementioned risks apply to specific companies and/or assets in your portfolio. As such, a prudent investor will always analyze the risk profile of each of their assets and then their portfolio as a whole.
What Is Systemic and Unsystematic Risk?
Before we discuss the risk analysis process, there is one more important point to cover.
Broadly speaking, financial risk can be classified into two categories. They are:
Systemic Risk is a risk due to the daily fluctuation of asset prices or external market factors. Also referred to as market risk. For example, stocks generally do well during bull runs and perform negatively during bear runs. Systemic Risk is something that cannot usually be mitigated (it is built into the system).
Unsystematic Risk is a risk specific to the company or investment. It can be eliminated or reduced through risk management strategies such as diversification. Examples include a product recall at a company or the emergence of a competitor.
How To Perform the Risk Analysis Process
“The sky is the limit. Being aggressive does not mean being undisciplined. You can be disciplined, but you should not set your targets low in financial markets” – Alex Gurevich, Macro Hive Podcast Episode 87
There is no one-size fits all method when it comes to the risk management process. How you manage your risk will be dependent on your risk tolerance, the assets you are invested in, and the country/state where you live.
However, there is a three-step plan that can be used as a starting point by all investors, and it should generally apply to every portfolio.
This is the first thing you can do. If you deem an investment to be too risky, avoiding it might be your best bet. However, as stated by Alex Gurevich above, this would also require you to limit your returns, as risk and return go hand in hand.
Remember that unsystematic risk can always be reduced and in some cases eliminated completely. Of course, proper due diligence is the best way to reduce risk. However, there are other methods as well:
- Make sure enough of your portfolio is significantly diversified. While diversification does not have to mean investing in a hundred different assets, it does mean not putting all your eggs in one basket (or two or three baskets, for that matter). At Macro Hive, we consider diversification actively when construction our Asset Allocation report, which will help you build a balance portfolio to weather the storm in 2023.
- It is also important to have sufficient liquidity in your portfolio to effectively deal with any short-term capital requirements. Cash is a common type of highly liquid, defensive asset, and it can help protect your portfolio in a downturn.
- Avoiding excessively risky strategies like timing the market is generally a great way to manage financial risk. Instead, focus on proper research and staying in the market.
- It is best to stay on top of macroeconomic developments. During riskier times, shifting to safer assets such as bonds and/or blue-chip stocks is usually a good idea. Investors looking for a weekly briefing on key macro risks can subscribe to Macro Hive Lite – our free weekly newsletter.
- Designing a strategy according to your investment risk profile and sticking to it typically leads to long-term benefits.
- Most important of all, constantly monitor your portfolio, as its risk profile of it will change according to the assets/companies you invest in and the broader market conditions.
The last thing you can do is transfer risk. Here, part or all of the risk is transferred to a third party. This can be done through the use of derivatives like options and futures contracts. At the advanced level, it can also be done through instruments like Credit Default Swaps.
Risk Management And Psychology
As it should be obvious to anyone in the world of investing, psychology plays a very important role – it makes up 80% of the investment process, according to research. This is primarily because investors often tend to be loss-averse. This is a bias that states that investors tend to prioritize not losing money over making more money.
While the exact level of loss aversion cannot be measured, reasonably accurate estimates place the negative impact of losses to be twice as much as the positive impact of an equivalent gain. Understanding the underlying psychology can be a great help to investors looking for better risk management. In particular, investors should learn to anticipate their regret.
Our recent podcast with Founder and CEO of ReThink, Denise Shull, is packed with information on how emotions and psychology play a part in risk management. As she says, ‘we think we make decisions based on our analysis. We think we make decisions based on how we’ve learned to understand the market and then we do this analysis and we make this prediction. That’s actually not what we make the decision on. We make the decision on our confidence in that analysis.’
Value At Risk
There are many tools that can help mitigate the impact of psychology on your portfolio. Value at risk (VaR) is the most common. VaR is essentially a measure of the loss that would arise in a tail-case scenario. This scenario is determined by a statistical confidence level.
VaR is determined by the period of the investment and the degree of certainty that the investor wants. For example, a $500 investment for a period of 6 months may only have a VaR of $50 at a confidence level of 95%, but it may have a VaR of $80 at a confidence level of 99%.
VaR is just one of the methods of reducing psychology in investments, and it comes with its own disadvantages. For example, an outlier event like the Coronavirus pandemic may render VaR and all of its models obsolete. As such, these calculations should be taken with a grain of salt.
Investing is not just about finding the right companies to invest in, as a good risk management plan can make all the difference between a portfolio with average returns and one with great returns.
Investors should monitor their portfolio constantly and adjust it according to their investment risk profile. Reducing risk is generally the easiest option for retail investors, but transferring risk or avoiding risk in the first place are also good alternatives. It is important to remember that financial risk is inherent in the markets, and it cannot be removed completely.
To learn how to build a balance equity portfolio for 2023, investors can follow John Tierney’s weekly insights.
What Is Risk?
It is the possibility of experiencing a loss on an investment. It is usually determined in terms of the probability of financial loss and the uncertainty of it happening.
What Is an Example of Risk Management?
One of the simplest ones would be an investor reducing their exposure to corporate bonds and buying treasury bonds if they foresee an economic downturn.
During a recession, chances are that a lot of companies would have trouble making interest payments. This could cause them to default or have their credit rating downgraded. Since this would result in a material loss, the investor can manage their risk by switching to treasury bonds (a much safer investment, albeit with a lower return as well).
What Is the Goal of Risk Management?
The fundamental goal of risk management is to reduce an investor’s exposure to risk. This is done by taking conscious steps that eliminate or reduce uncertainty in the investor’s portfolio. Usually, investors try to optimize the number of high and the number of low risk investments they own.
What Are the Principles of Risk Management?
Key principles of the risk management process:
- A lot of risks can be eliminated, but there will always be some risk attached to investing.
- Risk and return are inherently correlated. Investors can choose to avoid risk, but that would come at the cost of a lower return. It is best for investors to make decisions according to their investment risk profile.
- A better option for investors is to try and reduce risk. If that is not possible, transferring risk is another option.
- Risk management is a never-ending process, as new developments invariably lead to investors having to account for the rise or fall in their portfolio’s overall risk.