What is it?
Risk Management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.
Risk is inseparable from returns in the investment world.
Inadequate risk management can result in severe consequences e.g. subprime mortgage meltdown in 2007 that helped trigger the Great Recession stemmed from bad risk management decisions.
How to measure risk
A variety of tactics exist to ascertain risk; one of the most being standard deviation, a statistical measure. (of dispersion around a central tendency).
Beta, also known as a market risk, is a measure of the vocality, or systematic risk, of an individual stock in comparison to the entire market.
Alpha is a measure of excess return. Managers who employ active strategies to beat the market are subject to alpha risk.
In simple terms how much volatility (measured by standard deviation) an investor should accept depends entirely on the individual investor's tolerance for risk.
The use of Beta and Alpha in a portfolio is best understood by the graph below.
In simple words Beta is the gradient of the line. And it means that a a manager employing a passive management strategy can attempt to increase the portfolio return by taking one more unit of risk and vice versa.
Active managers hunt for Alpha - the measure of excess return. In the above diagram represented by "a".
According to "Investopedia" - "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, an example of alpha risk."
Types of Risk
Every saving and investment product has different risks and returns. Differences include: how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be. In this section, we are going to talk about a number of risks investors face. They include:Business Risk
With a stock, you are purchasing a piece of ownership in a company. With a bond, you are loaning money to a company. Returns from both of these investments require that that the company stays in business. If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. If there are assets, the company’s bondholders will be paid first, then holders of preferred stock. If you are a common stockholder, you get whatever is left, which may be nothing.If you are purchasing an annuity make sure you consider the financial strength of the insurance company issuing the annuity. You want to be sure that the company will still be around, and financially sound, during your payout phase.
Volatility Risk
Even when companies aren’t in danger of failing, their stock price may fluctuate up or down. Large company stocks as a group, for example, have lost money on average about one out of every three years. Market fluctuations can be unnerving to some investors. A stock’s price can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events.
Inflation Risk
Inflation is a general upward movement of prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. The principal concern for individuals investing in cash equivalents is that inflation will erode returns.Interest Rate Risk
Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
Liquidity Risk
This refers to the risk that investors won’t find a market for their securities, potentially preventing them from buying or selling when they want. This can be the case with the more complicated investment products. It may also be the case with products that charge a penalty for early withdrawal or liquidation such as a certificate of deposit (CD).(Disclaimer : this blog is for information only)
