What is Risk Management?
Risk management is the process of identification and mitigation of risk related to an investment portfolio. Risk can be examined on a micro-level or a macro-level, but it is important to recognize that risk is inseparable from fund performance. To achieve high returns in the long run, an investor must be willing to accept the short-term risk of volatility. Before an investor chooses to invest in a particular asset, they must decide on their risk tolerance––the capacity and desire to assume volatility. In general, risk tolerance is higher when an investor has more capital and a long time horizon for their investments.
On a macro-level, fund managers implement risk management by pursuing portfolio diversification. This involves investing in a combination of riskier assets (such as equities and ETFs) and safer assets (such as Treasury bonds). To further diversify the portfolio, fund managers invest in a variety of sectors; this allows for the fund to more accurately represent the market and minimizes sector-related risk. The exact proportion that is invested in certain asset classes and sectors depends on the investment goals and risk tolerance of the fund managers.
At the micro-level, risk guidelines can be applied to individual holdings. Beta, a measurement of covariance, indicates the movement of a stock in relation to the market. For instance, a beta greater than 1.0 suggests a stock’s returns are more volatile than market returns. A beta less than 1.0 indicates less volatility than the market. Strictly taking on market-related risk is referred to as passive risk management. Should investors seek to achieve excess returns by outperforming the market, they will expose their portfolio to alpha risk. This constitutes a more aggressive investment strategy that necessitates active risk management.
Risk management has evolved considerably since its modern inception after World War II. Corporations with significant asset holdings sought to diversify their portfolios as a method of self-insurance. Risk mitigation was employed as an alternative to market insurance, which was expensive and ineffective. Companies intensified their financial risk operations in the 1980s by creating internal risk management models and chief risk officer positions. When international agencies legislated risk regulations, governance and application of risk management became essential. Nonetheless, poor enforcement of risk regulations facilitated the financial crisis of 2007. Lenders had offered mortgages to people with poor credit, and investment offices and banks made the blunder of purchasing and reselling these mortgages. Had fund managers strictly followed risk management guidelines, they would have refrained from investing in mortgage-backed securities. In response to the crisis, Congress intervened with the introduction of the Dodd-Frank Wall Street Reform Act; the act prevented banks from assuming too much risk by allowing the Federal Reserve to limit their size and lending activities.