Risk Management in Finance

In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. We tend to think of "risk" in predominantly negative terms. However, in the investment world, the risk is necessary and inseparable from the performance.

A common definition of investment risk is a deviation from an expected outcome. That deviation can be positive or negative, and it relates to the idea of "no pain, no gain": to achieve higher returns, in the long run, you have to accept the more short-term risk, in the shape of volatility.

How Investors Measure Risk

Investors use a variety of tactics to ascertain risk. One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. You look at the average return of an investment and then find its average standard deviation over the same time period.

Risk and Psychology

The field of behavioral finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. Investors exhibit loss aversion: they put more weight on the pain associated with a loss than the good feeling associated with a profit. Value at risk (VAR) tool attempts to quantify how bad a loss on investment could be with a given level of confidence over a defined period.

Passive vs. Active Risk

Another risk measure oriented to behavioral tendencies is a drawdown, which refers to any period during which an asset's return is negative relative to a previous high mark. In measuring drawdown, we attempt to address three things: the magnitude of each negative period (how bad), the duration of each (how long), and the frequency (how often).

The Bottom Line

Risk is inseparable from return. Every investment involves some degree of risk, which can be very close to zero in the case of a U.S. Treasury security or very high for something such as real estate in Argentina. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs, and costs involved with different investment approaches.