Is Risk all Bad and No Good?
How should we view risks and why are they relevant in investing?
Risk is something that can’t be avoided — it is something that’s embedded in our day to day life. Everyone manages risk in their own ways while securing a certain level of utility. But regardless of the measures taken, there will still be a certain level of risks involved. In this article, we will focus more on economic and financial risk involved when we conduct our investments.
Risk can be looked at as uncertainty and they are closely interconnected with reward. In our day to day lives, we are often put in a position where we have to make choices. All of our choices have results and consequences. Similar to the world of investments, making a financial decision now will have implications in the future. To answer the questions within the title, risk if managed well can add utility to the decisions we made. I will be sharing the type of risk, how to conduct risk management, and the benefits of risk management.
Before we can implement any risk management strategy, we first have to be able to identify risks. Risk is separated into two broad categories, financial risk, and non-financial risk. All risks regardless of type are due to the unknown future.
Financial risks are linked to the financial market and consist of three primary types: Market risk, Credit risk, and Liquidity risk. Market risk is the risk related to development within an economy or industry or a specific company. Such development is closely related to the interest rates, stock prices, exchanges rates, and commodities pricing. Credit risk is the risk undertaken when one party is unable to commit to obligations such as bonds, loans or derivatives. This type of risk is sometimes known as default risk or counterparty risk. Lastly, liquidity risk is related to the ability to sell off a particular asset. Unlike market and credit risks, which are more common, liquidation becomes a problem for investors when they are not able to convert an asset into cash in the short term.
Non-financial risk excludes considerations in the financial market. Firstly, we have Compliance risks where it includes accounting, tax, legal and regulatory risks. This risk is dependent on external factors and volatility in the respective environment. The second type of risk is the Model risk where error arises from the valuation model we use. The third is Operational risk such as cybersecurity risks, which rely on the current technologies and terrorism threats. Lastly, we have ourselves — Mortality risk.
After understanding the different types of risk, we have to learn to distinguish if they are systematic or unsystematic risks. Systematic risks are known as undiversifiable risks, which are risks that are unavoidable and affect the market as a whole. Unsystematic risks are risks that affect only assets or industries and they are risks that are diversifiable.
Lastly, we have to understand our risk appetite. Risk forces us to optimize the value for every risk-decision made. During this process, we have to analyze the risk that we are about to assume. Study the asset shortfalls and uncertainties, and determine which are the ones that are acceptable based on your level of tolerance. A few of the ways we handle risk are through diversification or dollar-cost averaging. Alternatively, we can rely on professionals, however, we still have to keep up to date and stay involved. It is best to keep things simple — the more complex it gets, the least likely you will want to get involved. Risk management is like getting insurance but many of us only do so after a crisis has occurred. This process doesn’t have to be complicated but it requires consistency on your part to follow through.
“If you fail to plan, you are planning to fail!” — Benjamin Franklin
If done well, risk management has its own benefits. For one, we are less likely to be spooked during a shift in market sentiments. Better management of risk would also mean we would be more likely to enjoy better returns given the understanding of the risk-reward relationship. As mentioned in my previous article, if we were to conduct our due diligence, we are reducing our downside and increasing our probabilities of return. Lastly, we are able to respond accordingly when a crisis arises, minimizing our losses.
A takeaway for everyone is, risk management is not entirely about minimizing risk. It is a process where we define the level of risk we are willing to tolerate, a balance in the construction of our portfolio to achieve our desired investment goals alongside the probabilities of uncertainties.
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