Risk management in finance

What is Risk Management?

In finance, the process of risk management involves identifying, analyzing, accepting, or mitigating uncertainties in investment decisions. This typically involves attempting to analyze and quantify the likelihood of losses in an investment, including potential moral hazards.

Risk is an inherent part of income and investment. Every investment carries a certain level of risk, ranging from close to zero for U.S. government bonds to very high for investments such as emerging market stocks or real estate in high inflation markets. The degree of risk can be measured both in absolute and relative terms. A comprehensive understanding of the various types of risks can help investors to assess the opportunities, trade-offs, and costs associated with different investment strategies.

Understanding Risk Management

Risk management is a crucial aspect of finance, which can be observed in various areas. It is evident when investors prefer buying U.S. Treasuries over corporate bonds, fund managers hedge currency risk with foreign exchange derivatives, and banks evaluate the creditworthiness of borrowers before granting credit. Additionally, exchange brokers utilize financial products like options and futures, while financial managers adopt strategies such as portfolio diversification, asset allocation, and position sizing to manage or minimize risks.

However, improper risk management can have severe implications for businesses, individuals, and the economy at large. For instance, the collapse of low-quality mortgages in 2007, which led to the global economic downturn, resulted from inadequate risk management decisions. These included lending money to borrowers with poor credit, investment firms purchasing, packaging, and reselling these mortgages, and funds overvaluing investments in over-packaged Mortgage-Backed Securities (MBS).

How Risk Management Works

Although the term "risk" is often perceived negatively, it is an essential element in the world of investing. Investment risk is commonly defined as a deviation from expected outcomes, which can be measured in comparison to other benchmarks such as absolute performance or market indices.

These deviations can be either positive or negative, but it is generally acknowledged that taking more risk can lead to higher returns. However, increased risk is typically associated with higher volatility, which investment professionals seek to minimize. There is no consensus on the best approach to managing volatility.

The level of volatility that an investor should tolerate depends on their risk tolerance or, in the case of investment professionals, their investment objectives. Standard deviation is a widely used measure of absolute risk that indicates the spread around a central trend. By examining the average return on an investment and the average standard deviation over the same period, investors can assess risk numerically. A normal distribution suggests that investment returns are likely to deviate from the average by 1 standard deviation 67% of the time and by 2 standard deviations 95% of the time.

Investors should only take on risk if they are comfortable with both the economic and emotional consequences.

Example

To illustrate this concept further, let's consider the example of the S&P 500 from August 1, 1992 to July 31, 2007. Over the entire 15-year period, the S&P 500 had an average annual compound return of 10.7%. However, this figure doesn't reveal what happened during the period.

The average standard deviation of the S&P 500 index over the same 15-year period was 13.5%. This indicates the degree of deviation from the average return at any given point during the period.

Applying the bell curve model, we can expect that about 67% of the time, the actual return will deviate from the average return by 1 standard deviation, or about 13.5% in this case. Similarly, about 95% of the time, the deviation will be within 2 standard deviations, or about 27%. Therefore, S&P 500 investors can expect a deviation from the average return of 10.7% by plus or minus 13.5% in about 67% of cases.

Ultimately, an investor should only invest if they are willing and able to tolerate the potential economic and emotional risks associated with the investment.

Risk Management and Psychology

In other words, VAR provides investors with a statistical measure of the maximum potential loss for a specific investment, given a certain level of confidence, over a given period of time. For example, a 95% confidence level means that the investor can be 95% sure that the investment’s losses will not exceed the VAR during the specified period.

VAR has become an essential tool for financial institutions and regulators to manage risk. By using VAR, investors can better understand the potential downside of an investment and can make more informed decisions about their portfolio. However, it’s important to keep in mind that VAR is not a perfect measure and should be used in conjunction with other risk management tools and techniques.

Beta and Passive Risk Management

A measure of risk that focuses on behavioral trends is called drawdown, which refers to the period of time when asset returns are negative in comparison to past peaks. When measuring drawdowns, there are three things that need to be considered: the size of each negative period, the length of each period, and the frequency of these periods.

To assess the relative risk of an S&P 500 mutual fund, we not only want to know if it has won or lost, but also how risky it is. One measure of this risk is beta, which is a measure of "market risk" based on statistical covariance. A beta greater than 1 indicates that the fund is riskier than the market, while a beta less than 1 indicates that it is less risky.

Beta helps us understand the concept of passive and active risk. The graph below depicts the time series of a portfolio's returns (R(p)) as a function of market returns (R(m)), adjusted for cash. The intersection point of the x and y axes represents the cash-equivalent return. By fitting optimal lines through the data points, we can measure passive risk (beta) and active risk (alpha).

The slope of the line represents beta. For example, a slope of 1.0 indicates that for every unit of market return, the portfolio return also increases by one unit. A fund manager who adopts a passive management strategy can increase portfolio returns by taking on more market risk (i.e., a beta greater than 1), or reduce portfolio risk by decreasing the portfolio's beta (and income) below 1.

Alpha and Active Risk Management

If only market level or systemic risk is impacted, portfolio returns will always match beta-adjusted market returns. However, this is not always the case as returns are influenced by various factors independent of market risk. Active investment managers pursue different tactics to generate higher profits than market performance. These tactics encompass stock, sector or country selection, fundamental analysis, position sizing, and technical analysis.

The primary objective of active managers is to seek out Alpha, an indicator of excess returns. In the above chart, alpha is the value of portfolio returns not accounted for by beta, represented as the distance between the x and y-axis intersections, and can be either positive or negative. In the quest for higher profits, active managers expose investors to alpha risk, which is the risk that their bets will not generate positive results but rather negative outcomes. For instance, fund managers may believe that the energy sector will outperform the S&P 500 Index and, therefore, increase the weighting of their portfolios in that sector. If there is an unforeseen economic downturn causing energy stocks to plummet, managers may perform below the benchmark, illustrating an example of alpha risk.

Risk Costs

Typically, active funds and their managers that demonstrate a higher ability to generate alpha strategies charge investors higher fees for accessing these higher alpha opportunities. For passive investment instruments like index funds or exchange-traded funds (ETFs), investors generally pay annual management fees ranging from 1 to 10 basis points (bps). On the other hand, for hedge funds that use complex trading strategies requiring significant capital commitments and transaction costs, investors may have to pay annual fees of 200 basis points. Additionally, these funds may return 20% of the profits to the manager.

The cost differential between passive and active strategies (or beta and alpha risks) leads many investors to allocate these risks differently, such as paying lower fees for perceived beta risks and allocating more expensive risks to specific alpha opportunities. This concept is known as portable alpha, where the alpha component of total return is separated from the beta component.

For instance, a fund manager may claim to have an active sector cyclical strategy that outperforms the S&P 500 Index, with an average annual return of 1.5% over the index. For investors, the excess return of 1.5% represents the value of the manager, or alpha, and they may be willing to pay a higher fee to access it. The remaining total return, i.e., the return generated by the S&P 500 itself, may not be related to the unique abilities of the manager. The portable alpha strategy utilizes derivatives and other tools to optimize the acquisition and payment of the alpha and beta components of risk.