This post discusses investment risk and investment risk management. In this post, you will understand the meaning of investment risk and the management of investment risks.

WHAT IS A RISK?

Risk is a fundamental part of any investment. In financial terms, the risk is the possibility of things not going as expected. An investor’s risk should be a personal decision influenced by several factors. Risk can be subjective as only some might find a 50/50 chance of return risk, while most, if not all, will agree that even a 5% chance of return is a risk. Some investment risks can be controlled or mitigated. For example, an investor can double-check documents and do market research to ensure a property is in a good state before you invest in it. However, there is no way to guarantee a return on your investment since property values are outside your control over time. For example, prices may increase by 10% within a year or fall by 20% in a few months.

WHAT IS AN INVESTMENT RISK?

Investment risk is the probability or likelihood of losses relative to the expected return on any particular investment. Generally, a certain level of risk is involved in all kinds of investments. Management of risk is essential to ensure a sound investment strategy. An effective way of controlling risk is by spreading investments across different industries and sectors. This is necessary to ensure that all investment is not committed to the same kind of investment, such as stock market, real estate, or any other type of investment. 

In financial terms, risk can be described as the possibility of things not going as expected. Some risks can be controlled or mitigated. For example, an investor wanting to invest in a property should control and minimise risk exposure. For instance, an investor can reduce risk by double-checking documents and undertaking market research to ensure the property is in good standing before investing. This implies that all investments entail some degree of risk. Individuals, professional money managers, financial institutions, and many other investment-related professionals must manage investment-related risks in the financial world. 

Investors can either accept or try to mitigate the risk in investment decision-making. If they choose inaction and engage in inadequate risk management, they will likely experience severe consequences. If investors take appropriate actions given their investment objectives and risk tolerances, they may reduce the potential for investment losses. Hence, an investment risk management system should be proactive.

LEVELS OF INVESTMENT RISKS

It is beneficial for an investor to diversify his portfolio by investing in a mix of high, low, and medium-risk investments. Therefore, there are three levels of investment risk: low-risk, medium-risk, and high-risk.

FACTORS INFLUENCING INVESTORS’ RISK ATTITUDE

Some investors focus mainly on returns and how fast they can grow their money. Others protect themselves against the inevitability of a correction or a bear market by using various risk management strategies. Investors who can preserve their capital during difficult periods will have a more extensive base to grow from when good times return. That cautiousness does not mean they are paralysed with fear, stuffing money under the mattress or sticking only to the safest investments they can find. 

Investment risk management ensures that losses never exceed an investor’s acceptable boundaries. It is about understanding the level of risk a person is comfortable taking risk and building an investment portfolio with appropriate investments. Three main factors usually determine an investor’s risk tolerance: risk capacity, need, and emotions.

TYPES OF INVESTMENT RISK

The primary purpose of investment risk management is to provide an in-depth examination and management of risks associated with an investment. Risk management is essential because it can reduce or augment risk depending on the goals of investors and portfolio managers. Furthermore, managing risk has become increasingly difficult due to the multiple aspects of risk. Several risks are associated with an investment, including interest rate risk, equity risk, currency risk, liquidity risk, credit risk, inflation risk, concentration risk, horizon risk, reinvestment risk, longevity risk, and foreign investment risk. 

1. Interest Rate Risk

Interest rate risk arises due to debt investments such as bonds. Interest rate risk is the potential for investment losses that result from a change in interest rates. It is the risk of losing money due to a change in the interest rate. 

2. Equity Risk

Equity risk is the financial risk of holding equity in a particular investment. Equity risk is the risk of loss due to a drop in the market price of shares. Equity risk often refers to equity in companies through the purchase of stocks. 

3. Currency Risk

Currency risk (also referred to as foreign exchange risk, FX risk and exchange-rate risk) arises from changes in the price of one currency to another. Institutional investors (hedge funds, mutual funds, and multinational corporations) use forex, futures, options contracts, or other derivatives to hedge currency risks.

4. Liquidity Risk

Liquidity is the ability of an individual or a company to pay its debts without suffering catastrophic losses. Liquidity is a company’s ability to meet its cash and collateral obligations without sustaining unacceptable losses. Organisations can manage their liquidity risk through effective asset-liability management.

5. Credit Risk

Credit risk is a significant risk facing banks and other businesses. Credit risk applies to debt investments such as bonds. There are two components of credit risk: default risk and recovery risk. Default risk estimates the likelihood of default, while recovery risk measures the recovery in the event of default. 

6. Inflation Risk

Inflation risk is a risk of reduced purchasing power if an investment does not grow faster than the inflation rate. Inflation erodes the purchasing power of money over time, and the same amount of money will buy fewer goods and services. Inflation is outside the control of individuals and businesses. Rising prices can affect cash investments.

7. Concentration Risk

Concentration risk is the risk that an investor will need more diversification, investing too heavily in one industry, geographic area or one type of security. Concentration risk is a loss arising from a prominent position in a single asset or market exposure. An excessive concentration can give rise to liquidity risk or market risk losses. 

8. Horizon Risk

Horizon risk is the risk that an investment horizon or capability will be shortened due to an unforeseen event, e.g., losing an investor’s job. The investor’s investment capability may be cut short due to unfortunate events such as losing his job. This might force the investor to sell its long-term investments. If the investor sells his investment when the market is down, he may lose money.

9. Reinvestment Risk

Reinvestment risk is a risk of loss from reinvesting principal or income at a lower interest rate. Suppose a person buys a bond paying 6%. Reinvestment risk will affect the investor if the interest rate has reduced and the fund is reinvested at a regular interest rate of 5%. Reinvestment risk also applies if the bond matures and the investor reinvests the principal at a reduced interest rate of less than 6%. Reinvestment risk will not apply if the investor intends to spend the regular interest payments or the principal at maturity.

10. Longevity Risk

Longevity is a risk of outliving one’s savings. Longevity risk refers to the chance that life expectancies and actual survival rates exceed expectations or pricing assumptions, resulting in greater-than-anticipated cash flow needs on the part of insurance companies or pension funds. Longevity risks arise due to the increasing life expectancy trends among policyholders and pensioners and the growing numbers of people reaching retirement age. 

11. Foreign Investment Risk

Foreign investment risk is a risk of loss associated with investing in foreign countries. Those who buy foreign investments are exposed to foreign investment risks.

COMPONENTS OF RISK ANALYSIS

The three main components, referred to as the “three Ms” of risk analysis, are modelling, measuring, and managing risks.

1. Modelling Risk: Identifying economically dangerous uncertainties and their associated risk factors. Modelling risk also includes observing data and estimating probabilities to quantify and control the risk.

2. Measuring Risk: This relates to a quantitative assessment of the amount of risk caused by the methodology used to measure risk.

3. Managing Risk: consists of all actions needed to mitigate the risk and alleviate the consequences of unwanted events. It involves selecting appropriate risk-management techniques, making optimal decisions, and implementing and reviewing the risk-management process.

INVESTMENT RISK MEASUREMENT TOOLS AND TECHNIQUES

Risk management is essential in many sectors, especially banking, insurance, and finance. Risk management is an integral part of corporate management. Risk is the uncertainty of financial loss. Quantifiable risk can be described based on profit-and-loss distributions arising from risk factors based on a firm’s actions. Risk measures think like volatility or Value at Risk (VaR), highlighting such distributions’ properties (favourable or unfavourable). 

Modern Portfolio Theory is a standard financial and academic methodology for assessing a stock or fund’s performance compared to its benchmark index. Risk measures are statistical measures that are historical predictors of investment risk, and volatility is an essential component in Modern Portfolio Theory. Risk measures can be used individually or together to perform a risk assessment. The actions taken should be at minimal costs. 

When comparing two potential investments, it is wise to compare the investments to determine which investments constitute high risks. There are several tools and techniques for measuring investment risk. There are seven standard measures of investment risk, each providing a unique way to assess the risk associated with investment opportunities. The seven measures include alpha, beta, R-squared, standard deviation, Sharpe ratio, value at risk and conditional value at risk.

INVESTMENT RISK MANAGEMENT

The effectiveness of an investment risk management framework depends on the investment objectives and associated risks, the quantification of those risks, the process for managing those risks and the monitoring of the entire process. Mathematical distributions can define not all risks, and some risks are difficult to measure. While managing investment portfolios, managers should consider the intended risks and other risks that can impact the returns. The implication is that investment risk management is the foundation of a well-run investment process. 

Investment managers should assure clients that their assets are managed based on the formulated investment strategy. During the investment strategy formulation, a greater focus on expected returns and a lesser focus on risk may mismatch between the investment objective and risk appetite. A firm’s risk management culture, size, location, and scope impact the organisation’s practices and investment control measures. Due to the increased level of regulators scrutinising controls on risk management practices, investors and investment managers are expected to comply with minimum levels of best practices in risk management to ensure a sound investment management framework.

PRINCIPLES OF AN EFFECTIVE INVESTMENT RISK MANAGEMENT

The global financial crisis brought risk management to the forefront and highlighted how the absence of an all-encompassing risk framework might prove disastrous for asset managers. During the crisis, the market’s behaviour showed that risk management practices failed significantly when they were most needed, as the risk extended to previously uncorrelated asset classes. 

Although such Black Swan events may be impossible to predict ex-ante, implementing a comprehensive investment risk framework helps asset managers manage risk for standard times and be mindful of and prepare for such extreme events. So, what does sound risk management mean for asset managers? The principles of a practical investment risk management framework are based on the investment objectives and expectations around risk, quantifying, managing, and overseeing the entire process.

INVESTMENT RISK MANAGEMENT FRAMEWORK

Risk management is a mechanism for measuring, monitoring, and preventing loss, but it serves a broader and more practical purpose in investment risk management. Investment management risks can be categorised into two broad categories: 

1. investment risks associated with an alpha, and 

2. investment risks are strictly characterised by loss. Market risk provides opportunities for upside and downside (i.e., favourable and unfavourable) market risks.

INVESTMENT PORTFOLIO RISK CONTROL

Risk management is closely related to finance and investment, which is necessary for measuring performance. Understanding risks are, therefore, a crucial part of building financial and investment knowledge. Before making any investment, it is common for us to explore its benefits. It is, however, more important to be aware of the risks involved in an investment. Any investor would agree that ignorance and lack of awareness in the investment field can be expensive. 

Here are three steps to control risk associated with investment portfolio:

Step 1: Understand risk management

Step 2: Establish risk profile

Step 3: Creating a controlled risk profile

HOW TO MANAGE INVESTMENT PORTFOLIO RISK

Here are five ways to manage investment portfolio risk:

1. Follow the trend,

2. Rebalancing,

3. Position sizing,

4. Stop loss orders, and

5. Diversification.

See video on Operational Risk and Operational Risk Management: https://youtu.be/-EHq-Tna97A