Risk Management
"Opportunity and Risk Come in Pairs."
- Bangambiki Habyarimana
(Well-known Rwandan author, community worker, and education counselor.)
A Common Definition for Investment Risk = Deviation from an Expected Outcome.
Risk Management occurs everywhere in the financial world and in everyone’s daily decision-making process. 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.
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).
If there are 20 possible independent events
Each with a 5% probability of happening
The probability of (at least 1) happening is 64%
Risk: The Good, the Bad, & the Necessary
We are programmed to associate "Risk" in predominantly negative terms.
However… In the investment world: Risk is necessary & inseparable from performance.
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. This 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 must accept more short-term risk, in the shape of volatility).
How much volatility? This will depends on your Risk Tolerance.
Risk Tolerance is an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, considering your psychological comfort with uncertainty and the possibility of incurring large short-term losses.
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.