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Risk Management and Psychology

In the world of finance Risk management refers to the identifying of, analysis, and acceptance or reduction of uncertainty when making the investment decision-making process. In essence, risk management happens when an fund manager or investor analyzes and attempts to determine the possibility of losing money from an investment like moral hazard. The fund manager then decides to take the appropriate decision (or decision) depending on the investment goals of the fund and the fund’s risk tolerance.

The risk is not separate from the return. Every investment comes with a degree of risk. It is considered to be zero for an U.S. T-bill or quite expensive for something like emerging market equities or real estate in high inflation markets. Risk can be measured both in absolute as well as the context of relative. An knowledge of risk in its diverse forms can help investors better comprehend the risks, opportunities, trade-offs and the costs associated with various investment strategies.

Important Takeaways

The process is called risk management. It involves the identifying of, analysis, and acceptance or reduction of risk in investment decisions.
Risk is interconnected with return within the world of investment.
There are a variety of methods to determine risk. One of the most popular is the standard deviation, which is a measure of statistical the dispersion of a central trend.
Beta, also referred to as risk of market, a measurement of the level of volatility, or risk of an individual stock contrast to the whole market.
Alpha is a measurement of excessive return; managers who use aggressive strategies for beating the market can be vulnerable to risk of alpha.

What’s Risk Management?

Understanding Risk Management

Risk management can be found all over finance. It is when an investor purchases U.S. Treasury bonds over corporate bonds, or when the fund manager hedges his risk of currency exposure by using derivatives for currency, or when a bank conducts an inquiry into the creditworthiness of the person before granting an individual credit line. Stockbrokers utilize financial instruments, such as options and futures, while money managers utilize strategies like investment diversification and asset allocation, and positioning sizing to limit or manage risk effectively.

Poor risk management can have dire consequences for individuals, businesses and the overall economy. For instance the subprime mortgage crisis in 2007 which 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 resold these mortgages and funds that made excessive investments in repackaged, yet still risky mortgage-backed securities (MBSs).

Good or Bad, but also necessary Risk

We often imagine “risk” as primarily negative phrases. In the world of investment 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. It is possible to define this deviation in absolute terms, or in relation to something else, for instance, an index of market value.

Although the deviation could be negative or positive Investment professionals generally agree with the notion that a deviation is a sign of the desired outcome for your investment. In order to get higher returns, one should be willing to take on higher risk. It’s also a widely accepted notion that risk increases is a result of higher volatility. Investment professionals are constantly looking for — and sometimes find ways to lessen this volatility, there’s no agreement about the best method to achieve this.

How much risk an investor can tolerate is dependent on each risk-averseness of the investor or, for the investment professionals, what tolerance they have for their investment goals. The most widely utilized absolute risk metrics is the standard deviation, which is an indicator of the dispersion in the direction of a central tendency. When you look at the typical return on an investment, and then determine its average standard deviation during the same time. Normal distributions (the familiar bell-shaped curve) indicate that the expected return on investment will have a standard deviation below the average of 67 percent of the time, and 2-standard deviations to the standard deviation 95 percent all the time. This can help investors assess the risk mathematically. If they believe they can handle the risk financially and emotionally, they decide to invest.

The Psychology of Risk and Risk Management

Although this information could be useful, it will not completely address the investor’s risks. The area of behavioral finance provided significant elements into the overall risk-reward equation, 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 an aversion to loss. Tversky and Kahneman documented that investors place about twice as much importance on the hurt that comes with losses than the satisfaction that comes with making a gain.

Oft, what investors are looking for is not how much an investment is off from the expected result and how badly things appear on the left-hand end of the curve that is known as distribution. Value at Risk (VAR) seeks to give an answer to this issue. The purpose of VAR is to measure the amount of loss on investment can be at the same level of certainty for a specific time.

Of course, even a measurement like VAR does not guarantee that 5percent of the time will be the same as 5. The dramatic failures that afflicted the hedge fund Long-Term Capital Management in 1998 highlight the possibility that “outlier incidents” could occur. In the instance of LTCM the event that was out of the ordinary is an event that resulted in the Russian state’s inability to pay its sovereign obligations. This was which was threatening to ruin the hedge fund with highly leveraged positions that were worth more than $1 trillion. If the hedge fund had failed the pressure of default, it would have sunk the financial system worldwide. It was the U.S. government created a $3.65-billion loan fund to pay for the losses of LTCM, which allowed the company to withstand market’s volatility and liquidate its assets efficiently in the early 2000.