Over the last few years, risk management has become a big business. If you are involved in finance, whether as a professional or a novice investor, it is important that you have an understanding of risk and its implications on your investments. You need to be able to quantify risk to enable you to allocate assets to your portfolio which meet your risk appetite and your investment goals. Risk is not always to be avoided, as higher risk investments can yield greater rewards.
This type of risk, also known as default risk, describes the situation where a borrower fails to make payments as promised. This is of particular concern to those with bond investments and it is possible for an investor to lose his or her principal and interest. Professional asset managers have the benefit of specialised risk management software, such as that provided by APT. These incredibly complex systems enable us to calculate risk using models which can take into account numerous different risk factors at the same time.
This type of risk is the most familiar to the uninitiated and is also known as volatility. Market risk encompasses the constant fluctuations in stock prices, foreign exchange rates, interest rates and commodity prices. Volatility is essential in a market as it is these fluctuations that result in a profit (or a loss) for investors.
Foreign exchange risk
Where there is a foreign element to your investments, you will be exposed to fluctuations in the exchange rate between the two currencies. This means that even if you hold shares in a foreign company which appreciate in value, you could still lose money on your investment due to unfavourable changes in the exchange rate.
This is another category of risk that has been in the headlines recently, with Greece defaulting on its financial obligations. When a whole country is in default this will adversely affect all of the financial instruments and investments held within that country.
Operational risk encompasses an institution’s internal reputational, legal and I.T. risks. If there is a failure within a company, for example a large fine for money laundering due to inadequate systems, the reputation of the company could be irreparably damaged. This will have a dramatic effect on share prices. We have recently seen a number of well-known banks struggle with reputational risk after catastrophic I.T. failures and general bad management of the firm’s assets.
Avoiding risk by diversification
Risk cannot be avoided altogether and, without market volatility, there would be no profit to be made. A savvy investor will analyse and manage the risk attaching to their portfolio. One way of ensuring you only take on the desired amount of risk is to diversify your portfolio. Whilst some of your assets may make a loss, the hope is that your overall portfolio will mitigate this loss and still turn a profit. You could diversify in a number of ways, such as investing in different asset classes held in a variety of countries.
Avoiding risk by hedging
The other way to limit your risk exposure is by hedging, although this will generally be used by the professionals rather than amateur investors. To hedge a trade, a financial institution will purchase an option which offsets the original investment and guarantees a certain price should the option be exercised. If the original investment does not perform as well as expected, the investor can choose to exercise the option at a fixed price, thus mitigating their loss.