Explaining financial risk and risk management
In finance, "risk" refers to the possibility of losing money. In other words, financial risk is the potential for an investment to move against an investor's expectations (like a decrease in value). While risk is often associated with trading and investing, it permeates all aspects of the financial industry. From individual retail investors to international banks, everyone must account for risk when making economic decisions.
For example, banks and credit unions always ask for credit scores, employment information, and debt-to-income ratios before issuing loans. These factors help banks assess the "risk profile" of a potential borrower. If a bank feels a borrower has a high risk of default, they may not approve a loan.
Although it has a negative connotation, risk is unavoidable—and natural—in global financial markets. In fact, without risk, there would be no possibility of a return on their investment. The more risk someone is willing to take, the greater their potential for gains or losses. By contrast, "low-risk" investments, like bonds or Certificates of Deposit (CDs), have a higher chance of succeeding—but they offer diminished returns.
The field of risk management attempts to quantify how much risk someone is taking on. Investors use risk management tools to predict an asset's likelihood of working against them. In most cases, money managers use a combination of fundamental and technical analysis to gauge a financial decision's risk.
The risk management process
Every financial firm conducts research and manages risk using unique procedures—and they keep them close to the vest. However, there are several widely known strategies for protecting portfolios. Many investors use a "risk management process" strategy when reviewing their options. This four-step system provides a general outline to gauge an investment’s risk.
1. Identifying risks and defining an investment strategy
The first step in this risk management framework is identifying an asset's potential downside. Typically, investors look at "big picture" fundamental analytics during this initial stage. For instance, if a firm wanted to invest in a tech company, investors would likely read through previous earnings reports and study how the company's stock performed relative to the Nasdaq Composite—a stock market index of the stocks listed on the Nasdaq stock exchange. Investors also use macroeconomic data such as GDP, unemployment rates, and inflation to determine the potential impact on business operations.
In addition to identifying business risks, investors often define their risk tolerance, expectations, and strategy. Establishing a "risk threshold" ensures investors are comfortable with the expected volatility of their assets. A detailed investment thesis also helps money managers focus on long-term goals and take emotion out of decision-making.
There is no one-size-fits all risk strategy. Each person has their own risk tolerance, and they should therefore align their investments to what they can handle.
2. Analyze risk probability
After identifying an asset's primary opportunities and threats, analysts determine the most likely scenarios. Often, risk managers use probability theory and technical analysis to quantify the likelihood an asset will rise or fall.
Economists use statistical equations like standard deviation during the analysis phase. Standard deviation uses an asset's average historical price range to determine the expected volatility. Technical chart tools like "Bollinger bands" help analysts visualize the expected range a stock, ETF, or crypto will likely move within. While standard deviation isn't 100% accurate, it helps analysts predict the most likely outcomes.
It's also common for money managers to use "alpha" and "beta" scores to conduct risk analyses. "Alpha" measures the expected return for a single investment compared with the average return for a major index (for example, Tesla's stock versus the S&P 500). By contrast, "beta" focuses on the average volatility of one asset versus the entire market. Typically, the riskiest assets have high alpha scores and low beta scores, or vice versa.
3. Respond to risky circumstances
Professional investors prepare for worst-case scenarios by planning their response ahead of time. A solid risk management strategy has a clear "exit strategy" should an investment fail to deliver the expected results. With this strategy in place, investors know whether to hold, sell, or add to a position according to their risk tolerance and investment thesis.
4. Monitor data and investment results
Once a retail or institutional investor opens a position, they track their portfolio performance regularly with fundamental and technical analysis. In addition to following news specific to their assets, fund managers may analyze their risk-to-return ratio compared with the overall market or competing sectors. This data may force investors to reconsider or rebalance their portfolios.
Dealing with financial risk: 4 common responses:
If a financial risk materializes, people react in four common ways. Choosing between these responses depends on an investor's priorities and preferences.
- Risk avoidance: Investment firms prioritizing steady returns will proactively avoid volatile markets. Although crypto assets such as Bitcoin have significant upside potential, they're highly volatile. Risk-averse investors prefer to eliminate uncertainty rather than buy BTC.
- Risk mitigation: Mitigation is colloquially called "cutting your losses." In this scenario, an investor lowers some of their risk by selling a losing position that’s decreasing in value. While mitigation reduces potential upside should an asset recover, it also minimizes downward pressure if it continues to fall.
- Sharing or risk transfer: Financial institutions may reduce risk exposure by forming partnerships with other firms interested in a particular asset. Since each stakeholder has a percentage in "shared investments," everyone takes on a portion of the risk. In extreme situations, it's also possible for financial firms to transfer their risk to a third party, such as an insurance company.
- Risk acceptance: If investors have a long-term plan, they may "accept" short-term losses and hold their positions. The hope with "acceptance" is that the underlying assets will eventually rise. This hands-off approach is a hallmark of passive investment strategies.
The benefits of risk management
The primary benefit of risk management is that it prepares investors for undesirable scenarios. While risk management analysis can't predict the future, it empowers traders with an educated guess on potential outcomes. The more information investors have about an asset's risk profile, the more likely they make well-reasoned financial decisions and protect themselves from excessive losses. A thorough risk analysis helps people create portfolios that reflect their financial goals and volatility preference.
Proper risk control can also improve the health of the financial system. For instance, the U.S. Federal Reserve routinely screens national and local banks for potential risk factors such as their assets-to-debts ratios. These "Fed stress tests" help provide transparency and reduce the odds of banks going into default.
Best practices for risk management
Besides developing an initial risk management plan, investors can employ strategies to control risk. While the list of risk assessment metrics is long, a few practices are standard in the investing community:
- Diversification: Portfolios with diverse assets tend to have less risk than those concentrated in one industry. Investing across multiple sectors makes it more likely that some holdings will perform well and offset potential losses.
- Stop-loss: A stop-loss is an automated "sell" order that closes a position at a pre-defined level. These limit orders define how much money an investor will risk before opening a position.
- Hedging: Those familiar with derivatives may use options — or futures — to take the opposite side of their portfolio's long-term strategy (a process known as "hedging"). For instance, an Apple shareholder could buy AAPL “put options” before an earnings call. If Apple's stock falls, this investor could sell their put contracts for a profit, reducing their stock position's loss.
- Dollar-cost averaging (DCA): DCA involves regularly buying small amounts of an asset and holding it for the long term. Investors use DCA to reduce the average price for their favorite investments, especially during bear markets.
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