What Is Risk Management?
TIn 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. Risk is inseparable from return. 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. 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.
Key Takeaways
Risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.
A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statistical measure of dispersion around a central tendency.
Risk is inseparable from return in the investment world.
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.
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