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Home » What Is Risk Management in Finance, and Why Is It Important?

What Is Risk Management in Finance, and Why Is It Important?

In the financial sector risk management refers to the identifying as well as analysis and acceptance or reduction of risk in the investment decision-making process. The fundamental concept behind risk management is when an fund manager or investor analyzes and attempts to assess the possibility of losing money when investing, for example moral hazard, and decides on the best course of step (or or inaction) depending on the investment goals of the fund and the fund’s risk tolerance.

The risk is not separate from the return. Each investment carries a certain amount of risk. It can be considered as zero for the U.S. T-bill or quite expensive for something like emerging market equities and real estate in extremely inflationary markets. Risk can be quantified both in absolute as well as the context of relative. An knowledge of risk in its diverse forms can help investors comprehend the risks, opportunities, trade-offs and the costs associated in different investment strategies.

Important Takeaways

The process is called risk management. It involves the identifying of, analysis, and acceptance or reduction of the risk of investment decision making.
Risk is interconnected with return when it comes to investing.
There are a variety of methods to assess risk. One of the most commonly used is the standard deviation, which is an indicator of statistical the dispersion of a central trend.
Beta, also referred to by the name market risk is an indicator of the variability, or systematic risk of an individual stock relation to the market as a whole.
Alpha is a measurement of return that is above the market; managers who use aggressive strategies for beating the market can be vulnerable to risk of alpha.

What exactly is Risk Management?

Understanding Risk Management

Risk management is everywhere in finance. It happens when an investor purchases U.S. Treasury bonds over corporate bonds, or when the fund manager hedges his exposure to currency with derivatives for currency, or when a bank conducts an inquiry into the creditworthiness of an individual prior to granting an individual credit line. Stockbrokers utilize financial instruments, such as futures and options, and money managers utilize strategies like investment diversification and asset allocation, and the size of a position to reduce or manage risk effectively.

A lack of risk management could have dire consequences for businesses, individuals and the overall economy. For instance the subprime mortgage meltdown in 2007 that triggered the Great Recession stemmed from bad management of risk, for example the lenders who extended mortgages to those with low credit, investment companies that purchased, packaged, and then resold these mortgages and funds that made excessive investments in repackaged but still risky mortgage-backed securities (MBSs).

Good or Bad, but also necessary Risk

We often imagine “risk” as primarily negative in terms of negative. But in the world of investing it is a necessity and is inseparable from desired performance.

The most common definition of risk in investment is the deviation from the outcome that is expected. This deviation can be expressed in absolute terms or as a comparison to something else, for instance, the market benchmark.

Although this deviation can be negative or positive experts in investment generally agree the notion that a deviation is a sign of the desired outcome for your investment. Therefore, to earn higher returns one should be willing to take on higher risk. It’s also a widely accepted notion that risk increases results in greater volatility. Although investment professionals continuously seek – and often find ways to decrease this risk, there’s no consensus among them regarding the best way to do it.

The amount of volatility an investor is willing to accept is dependent on each risk-averseness of the investor or, for the investment professionals, what tolerance their goals for investing allow. The most widely utilized absolute risk metrics is the standard deviation, which is an indicator of the dispersion of a central trend. It is possible to look at the average return on an investment, and then calculate its standard deviation during the same time. Normal distributions (the familiar bell-shaped curve) suggest that the anticipated return of an investment will take one standard deviation below the mean of 67 percent of the time. It is 2 standard deviations away from the standard deviation 95 percent times. This allows investors to evaluate the risk mathematically. If they feel they are able to handle the risk financially and emotionally, they decide to invest.

The Psychology of Risk and Risk Management

Although this information could provide valuable information, it does not completely address the investor’s risks. The area of behavioral finance provided an important component in the equation of risk, showing an asymmetry in how people perceive the risk of losing and gains. According to the prospect theory, a field of finance based on behavioral principles, which was developed by Amos Tversky and Daniel Kahneman in 1979, investors show fear of loss. Tversky and Kahneman documented that investors place roughly double the importance on the hurt that comes with losing money than on the pleasure that comes from making a gain.

Most of the time, what investors need to know isn’t how much an asset is out of line with the outcome they expected and how badly things look on the left-hand end of the curve that is known as distribution. Value at Risk (VAR) seeks to give the answer to this question. The concept behind VAR is to determine the amount of loss on investment is possible with an attainable level of confidence over a specified time.

Of of course, a statistic like VAR does not guarantee that only 5% of the times will be the same as 5. The dramatic failures that afflicted the hedge fund Long-Term Capital Management in 1998 remind us that “outlier incidents” could occur. In the instance of LTCM an outlier event occurred as a result of that of the Russian state’s inability to pay its sovereign obligations. It was which was threatening to ruin the hedge fund that was heavily leveraged investments worth nearly $1 trillion. If the hedge fund had failed the pressure of default, it would have sunk the financial system of the world. It was the U.S. government created a $3.65-billion loan fund to pay for the losses of LTCM. This allowed the company to withstand market’s volatility and liquidate its assets efficiently at the beginning of 2000.