When we are talking about financial worth, risk management is the structured method of identifying, analysing and accepting or mitigating investment decisions laced with uncertainty.

Generally speaking, risk management occurs when a fund manager or an investor analyses and tries to categorise the potential losses in a current investment, including financial losses or moral hazards, going on to take appropriate actions to either increase risk tolerance or mitigate the risk entirely.

Return and risk cannot be separated. Every single investment brings some risk, which is considered close to zero in most cases. The quantification of risk can be done in both relative and absolute terms.

A comprehensive understanding of risk and its management, paying particular attention to the different forms of risk available, can aid investors in understanding hidden opportunities, inherent costs and trade-offs available with different investment approaches.

KEY TAKEAWAYS

Risk management is the structured method of highlighting, evaluating, accepting or mitigating hidden uncertainties in financial/investment decisions. Every return has some risk attached to it in the investment world.

A wide variety of tactics exist to evaluate risk, and one of the most common methods is standard deviation, a statistical method to measure dispersion around a central tendency.

risk management

Beta, another name for market risk, is a measure of systematic risk or volatility of an individual stock in comparison to the status of the entire market.

Alpha is another measure of excess return, and financial managers employ different strategies to beat the market curve and enhance alpha risk.

Reading the article “What Is Financial Risk” can also be useful for you in this regard.

Understanding risk management

Risk management is dispersed everywhere across the realm of finance. It can emerge when an investor buys bonds from the US treasury over corporate bonds or when a fund manager hedges his currency exposure with currency derivatives.

It can also arise when a bank performs a credit check on a person before issuing them a credit card. Stockbrokers utilise financial instruments such as futures and options to calculate risk, and money managers utilise such strategies to diversify their portfolios and allocate their assets. Portfolio diversification and asset allocation help to effectively mitigate and manage risk while simultaneously positioning assets.

Inadequate risk management can lead to severe consequences for the economy, companies and individuals. An unfortunate example is the subprime mortgage meltdown in 2007, which further triggered the great recession. The root cause of the great recession was later found to be lousy risk management decisions, such as extended mortgages to individuals with a poor credit history and investment firms that bought, repackaged and resold these mortgages.

Understanding risk management

We tend to think that risk is oddly predominant in negative terms; however, in the investment world, the risk is inseparable from desired performance. A standard definition of investment risk is a detour from the expected outcome. We can describe this deviation in either relative or absolute terms, similar to a market benchmark.

Although the deviation can be positive and negative, investment professionals generally accept that some deviation is necessary for your intended outcome to manifest.

One must learn to accept more significant risks to acquire higher returns than expected. Increased risk brings with it some form of increased volatility. Good investment professionals are the ones that occasionally find but are constantly seeking methods to reduce volatility so that there are greater returns than intended.

The volatility an investor can accept depends upon their risk tolerance ability or, in the case of an investment professional, how much tolerance their objectives allow. One of the most common risk metrics utilised is the standard deviation.

risk management

Standard deviation is a statistical measurement of the dispersion of variables around a central tendency. Therefore, when you try to identify the average return of an investment, you focus on the average standard deviation across a period. A bell-shaped curve indicates normal distribution that dictates that the expected return on investment is likely to occur.

If the standard deviation is agreeable, the average would be 67%, and if there is twice the amount of standard deviation, the average deviation would be 95%. Understanding standard deviation helps investors to evaluate risk quantitatively and numerically. The bottom line is that if investors believe they can financially and emotionally tolerate the risk, they go ahead with the investment.
Appropriate risk management strategies can result in better decision-making and keener evaluation of many vital trade-offs in investing, helping managers to optimise value. Appropriately applied strategies can lead to more efficient, consistent operations, increased focus on security, successful initiatives and a healthier bottom line.