In the financial world, risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management 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) given the fund's investment objectives and risk tolerance.
Every investment involves some degree of risk, which is considered close to zero in the case of a U.S. T-bill or very high for something such as emerging-market equities or real estate in highly inflationary markets. Risk is quantifiable both in absolute and in relative terms.
While you cannot predict too many things with certainty when it comes to financial planning, you can be sure that there will always be one thing: risk.
- You can manage risk in four ways
- What is risk management in personal financial planning? Complete process
- How Risk Management Works? Examples
- Why is risk management in personal financial planning important?
- Risk Management and Psychology
- Beta and Passive Risk Management
- Alpha and Active Risk Management
- The Cost of Risk
- How can you assess and mitigate risk in your financial planning?
- At the end of the process, you can replace that feeling of nervousness or doubt with...........
- Ready to take control of your risk?
Ready to learn how? This article will walk you through some of the key aspects of risk management, why it’s important to prioritize it, and the steps you can take to assess your risk.
Risk is the possibility of loss. Sometimes the loss is trivial, while at other times it may cause major personal and financial hardship. There is no way to eliminate all risk, but there are ways to avoid, minimize, or protect yourself and your family from risk. When risk is low, or the cost is not too high, it is easy to assume risk. When it is too costly to assume risk, you need other ways to manage it. Insurance provides a convenient way to manage financial loss due to catastrophic risk.
You can manage risk in four ways:
Assume riskWhen you assume risk, you do nothing to minimize the financial impact of loss should a hazard occur. For example, you don't buy fire or flood insurance on your home or you don't have life, disability, or health insurance coverage. Should a risk occur, you must pay the full cost of the loss out of your own assets. This can adversely affect your financial goals for you and your family.
Avoiding risk may not be easy, but there are ways to lower risk management costs by doing so. Risk avoidance can lower the financial cost of risk, which is why insurance premiums are lower for persons and businesses that take measures to lower risk. For example, automobile insurance premiums are lower for drivers with good driving records (no accidents and no cited violations of driving laws), and non-smokers pay lower medical insurance and life insurance premiums than smokers do.
- What is risk management in personal financial planning?
Behind every decision you make about how, when, and where to invest your money, risk is there lurking, making even the most experienced investors second guess their decisions or run through the numbers one more time.
However, instead of letting risk and the fear that it can give some personal investors scare you into not acting at all, you can learn how to control and mitigate it. That’s what risk management in personal financial planning is all about.
For some, the right risk mitigation strategy is to avoid taking the risk at all. For others, it is accepting the risks given the potential benefits. Others find a compromise, such as by starting with a small investment, balancing their investment with something not as risky, or by speaking with a financial professional about their options.
- How Risk Management Works
We tend to think of "risk" in predominantly negative terms. However, in the investment world, risk is necessary and inseparable from desirable performance.
A common definition of investment risk is a deviation from an expected outcome. We can express this deviation in absolute terms or relative to something else, like a market benchmark.
While that deviation may be positive or negative, investment professionals generally accept the idea that such deviation implies some degree of the intended outcome for your investments. Thus to achieve higher returns one expects to accept the greater risk. It is also a generally accepted idea that increased risk comes in the form of increased volatility. While investment professionals constantly seek and occasionally find ways to reduce such volatility, there is no clear agreement among them on how it's best done.
How much volatility an investor should accept depends entirely on the individual investor's tolerance for risk, or in the case of an investment professional, how much tolerance their investment objectives allow. One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. You look at the average return of an investment and then 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 is likely to be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time. This helps investors evaluate risk numerically. If they believe that they can tolerate the risk, financially and emotionally, they invest.
- Example
For example, during a 15-year period from August 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; he may also assume a 27% (two standard deviations) increase or decrease 95% of the time. If he can afford the loss, he invests.
- Risk Management and Psychology
While that information may be helpful, it does not fully address an investor's risk concerns. The field of behavioral finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory, an area of behavioral finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion. Tversky and Kahneman documented that investors put roughly twice the weight on the pain associated with a loss than the good feeling associated with a profit.
Often, what investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things look way down on the left-hand tail of the distribution curve. Value at risk (VAR) attempts to provide an answer to this question. The idea behind VAR is to quantify how large a loss on investment could be with a given level of confidence over a defined period. For example, the following statement would be an example of VAR: "With about a 95% level of confidence, the most you stand to lose on this $1,000 investment over a two-year time horizon is $200." The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve.
Of course, even a measure like VAR doesn't guarantee that 5% of the time will be much worse. Spectacular debacles like the one that hit the hedge fund Long-Term Capital Management in 1998 remind us that so-called "outlier events" may occur. In the case of LTCM, the outlier event was the Russian government's default on its outstanding sovereign debt obligations, an event that threatened to bankrupt the hedge fund, which had highly leveraged positions worth over $1 trillion; if it had gone under, it could have collapsed the global financial system. The U.S. government created a $3.65-billion loan fund to cover LTCM's losses, which enabled the firm to survive the market volatility and liquidate in an orderly manner in early 2000.
- Beta and Passive Risk Management
Another 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 draw down, 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 how comparatively risky it was. One measure for this is beta (known as "market risk"), based on the statistical property of covariance. A beta greater than 1 indicates more risk than the market and vice versa.
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. For example, a gradient of 1.0 indicates that for every unit increase of 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 Risk Management
If the level of market or systematic risk were the only influencing factor, then a portfolio's return would always be equal to the beta-adjusted market return. Of course, this is not 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. Active strategies include tactics that leverage stock, sector or country selection, fundamental analysis, position sizing, and technical analysis.
Active managers are on the 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, represented as the distance between the intersection of the x and y-axes and the y-axis intercept, which 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 under perform the benchmark, an example of alpha risk.
- The Cost of Risk
In general, the more an active fund and its managers shows themselves able to generate alpha, the higher the fees they will tend to charge investors for exposure to those higher-alpha strategies. For a purely passive vehicle like an index fund or an exchange-traded fund (ETF), you're likely to pay 1 to 10 basis points (bps) in annual management fees, while for a high-octane hedge fund employing complex trading strategies involving high capital commitments and transaction costs, an investor would need to pay 200 basis points in annual fees, plus give back 20% of the profits to the manager.
The difference in pricing between passive and active strategies (or beta risk and alpha risk respectively) encourages many investors to try and separate these risks (e.g. to pay lower fees for the beta risk assumed and concentrate their more expensive 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 example, a fund manager may claim to have an active sector rotation strategy for beating the S&P 500 and show, as evidence, a track record of beating the index by 1.5% on an average annualized basis. To the investor, that 1.5% of 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.
- How can you assess and mitigate risk in your financial planning?
While there are several different approaches, assessing and mitigating risk generally includes......
Identifying the potential investment risk, its cause(s), its potential to occur, and its consequences
Determining how much of the risk you are willing to accept
Developing strategies to mitigate the risk you choose to accept or eliminate the risk you are not
Once you move through these steps, come up with a plan, and implement it, it’s important to regularly reevaluate your decisions and calculations, especially when there is a significant change in your family, your career, or in the larger financial markets.
- Why is risk management in personal financial planning important?
In other words, risk management in personal financial planning is about helping you to make the best decision, limit the amount of emotion in the decision-making process, and help you to identify how much risk you are willing to accept given the potential gains.
- At the end of the process, you can replace that feeling of nervousness or doubt with...........
Knowing that you are more prepared for the unexpected
A portfolio of investments that are better able to protect your family, assets, and plans against the unknown
The knowledge that the potential gains and risk from your investments are balanced or are in a place that you feel comfortable with
- Ready to take control of your risk?
Understanding risk management in personal financial planning can be complex and constantly changing, but, fortunately, you don’t have to face these challenges alone.
Instead, you can have the experienced team at Harvest Wealth Group partner with you and provide our tools and knowledge to help guide you and your family through the decision-making process. In the end, you can have a better understanding of your potential risk, your plans to control it, and how your decisions align with your goals and values.
If you would like to learn more about risk management in personal financial planning, our team would love to get to know you. Contact us here to schedule a free consultation and, while you are at it, we also welcome you to download our free resource, 10 Things A Smart Investor Should Consider In an Economic Downturn.