What Is Risk Management in Finance, and Why Is It Important?

What Is Risk Management?

Risk management involves identifying, analyzing, and accepting or mitigating uncertainty in investment decisions. Put simply, it is the process of monitoring and dealing with the financial risks associated with investing. Risk management essentially occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment, such as a moral hazard, and then takes the appropriate action (or inaction) to meet their objectives and risk tolerance.

How Risk Management Works

Risk is inseparable from return. Every investment involves some degree of risk. It can come close to zero for U.S. T-bills or very high for emerging-market equities or real estate in highly inflationary markets. Risk is quantified 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.

Risk management involves identifying and analyzing where risk exists, and making decisions about how to deal with it. It occurs everywhere in the realm of finance. For instance:

• An investor may choose U.S. Treasury bonds over corporate bonds
• A fund manager may hedge their currency exposure with currency derivatives
• A bank performs a credit check on an individual before issuing a personal line of credit
• A stockbroker uses financial instruments like options and futures
• A money manager uses strategies like portfolio diversification, asset allocation, and position sizing to mitigate or effectively manage risk

Diligent risk management can help reduce the chance of losses while ensuring that financial goals are met. Inadequate risk management, though, can result in severe consequences for companies, individuals, and the economy. The subprime mortgage meltdown that led to the Great Recession stemmed from bad risk management. Lenders gave mortgages to people with bad credit and investment firms bought, packaged, and resold these loans to investors as risky, mortgage-backed securities (MBSs).

Risk Management Techniques

The following is a list of some of the most common risk management techniques.

• Avoidance: The most obvious way to manage your risk is by avoiding it completely. Some investors make their investment decisions by cutting out volatility and risk completely. This means choosing the safest assets with little to no risks.
• Retention: This strategy involves accepting any risks that come your way and acknowledging that they come with the territory.
• Sharing: This technique comes with two or more parties taking on an agreed-upon portion of the risk. For instance, reinsurers cover risks that insurance companies can't handle on their own.
• Transferring: Risks can be passed on from one party to another. For instance, health insurance involves passing on the risk of coverage from you to your insurer as long as you keep up with your premiums.
• Loss Prevention and Reduction: Rather than eliminate the potential for risk, this strategy means that you find ways to minimize your losses by preventing them from spreading to other areas. Diversification may be a way for investors to reduce their losses.

Risk Management and Volatility

Investment risk is the deviation from an expected outcome. This deviation is expressed in absolute terms or relative to something else like a market benchmark. Investment professionals generally accept the idea that the deviation implies some degree of the intended outcome for your investments, whether positive or negative.

To achieve higher returns, one expects to accept the greater risk. It is also a generally accepted idea that increased risk means increased volatility. While investment professionals constantly seek and occasionally find ways to reduce volatility, there is no clear agreement on how to do it.

How much volatility an investor should accept depends entirely on their risk tolerance. For investment professionals, it is based on the tolerance of their investment objectives. One of the most commonly used absolute risk metrics is standard deviation, which is a statistical measure of dispersion around a central tendency.

Here's how it works. Take the average return of an investment and 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 may be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time. This provides a numeric risk evaluation. If the risk is tolerable (financially and emotionally), they can invest.

Risk Management and Psychology

Behavioral finance highlights the imbalance between people's views of gains and losses. In prospect theory, an area of behavioral finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion. They noted that investors put roughly twice the weight on the pain associated with a loss than the good feeling associated with a profit.

Investors often want to know the losses that come with an investment as well as how much an asset deviates from its expected outcome. Value at risk (VAR) tries to quantify the degree of loss associated with an investment with a given level of confidence over a defined period. For example, an investor may lose $200 on a $1,000 investment with a 95% level of confidence over a two-year time horizon. Keep in mind that a measure like VAR doesn't guarantee that 5% of the time will be much worse.

It also doesn't account for any outlier events, which hit hedge fund Long-Term Capital Management (LTCM) in 1998. The Russian government's default on its outstanding sovereign debt obligations threatened to bankrupt the hedge fund, which had highly leveraged positions worth over $1 trillion. Its failure could have collapsed the global financial system. But the U.S. government created a $3.65-billion loan fund to cover the losses, which enabled LTCM to survive the volatility and liquidate in early 2000.

Types of Risk Management

Beta and Passive

One 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)
• 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 its comparative risk. One measure for this is beta. Also called market risk, beta is based on the statistical property of covariance. A beta greater than 1 indicates more risk than the market while a beta less than 1 indicates lower volatility.

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. So a gradient of 1 indicates that for every unit increase in market return, the portfolio return also increases by one unit. A money 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 one.

Alpha and Active

If market or systematic risk were the only influencing factor, then a portfolio's return would always be equal to the beta-adjusted market return. But this isn't the case. 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, including:

• Tactics that leverage stock
• Sector or country selection
• Fundamental analysis
• Position sizing
• Technical analysis

Active managers 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, which is represented as the distance between the intersection of the x and y-axes and the y-axis intercept. This 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 fund 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.

The Cost of Risk

The more an active fund and its managers can generate alpha, the higher the fees they tend to charge. For purely passive vehicles like index funds or exchange-traded funds (ETFs), you're likely to pay one to 10 basis points (bps) in annual management fees. Investors may pay 200 bps in annual fees for a high-octane hedge fund with complex trading strategies, high capital commitments, and transaction costs. They may also have to give back 20% of the profits to the manager.

The pricing difference between passive (beta risk) and active strategies (alpha risk) encourages many investors to try and separate these risks, such as paying lower fees for the beta risk assumed and concentrating costly 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 instance, a fund manager may claim to have an active sector rotation strategy for beating the S&P 500 with a track record of beating the index by 1.5% on an average annualized basis. This 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.

Example of Risk Management

During a 15-year period from Aug. 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. They may also assume a 27% (two standard deviations) increase or decrease 95% of the time. If they can afford the loss, they invest.

The Bottom Line

Risk is an important part of the financial world. The word often brings up feelings of negativity since there is the potential for capital and investment loss. But risk isn't always bad because investments that have more risk often come with the biggest rewards. Knowing what the risks are, how to identify them, and employing suitable risk management techniques can help mitigate losses while you reap the rewards.