ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

Risk Management: A Beginners Guide.

Updated on January 19, 2012
one2get2no profile image

Philip retired from investment banking to write. To date he has written 9 books on trading forex, 3 short stories, and one poetry book.

Risk Management - A Beginners Guide

Investment management rests upon some common beliefs about the nature of risk and return. Now let's look at the concept of risk management. In this article we are looking at investment risk in general and will not be discussing risk management software or any other technological tool. Other articles will explore the concepts of credit risk, business risk, corporate risk, banking risk, financial risk and market risk in greater detail.

Risk is measurable; meaning the distribution of an outcome in a group of instances is known. Risk is different from uncertainty, where the distribution of outcomes is unknown. This graph shows one way to measure the risk of stocks, which are the distributions of various stock returns.

Standard Deviation Bell Curve - Courtesy of Wikipedia
Standard Deviation Bell Curve - Courtesy of Wikipedia

The Bell Curve

The bell curve is showing standard deviation of a stocks return. Say that the expected return of this stock is around 3%, then 68% of the time at a standard deviation of 1 the stock will roughly achieve the return of 3%. However, 14% of the time at a standard deviation of 2, its return will be between 1% and 3% and 14% of the time the stock will achieve a return between 3% and 5%.

We will return to this concept later.

Let’s further define risk as a priori risk, that with fixed proportions such as the numbers on a die, and statisti­cal, that for which records or statistics of past experience exist, like stock pric­es. You may recall from your statistics courses at school that the shape of the graph as in the example below indicates the amount of variance of the stock's returns. The buy points are at the bottom of the valleys and the sell points at the top of the peaks.

Risk Management Graph
Risk Management Graph

We may also divide risk into Systematic and Unsystematic risk. Systematic risk is the risk on any individual stock that is due to conditions affecting the market as a whole.

Unsystematic risk is risk unique to a specific company,such as management decisions, new government regulations or a strike etc.

Managing Risk (Avoidance)

How can we manage risk? Well risk can be managed in four distinct ways through avoidance, diversification, consolidation and/or specialization.

Let’s decide how to invest some money. We have many choices in front of us. For example, we can put our money in a regular bank account. This offers us virtually risk free investment because bank accounts are insured by the US Government and many other western governments up to a specified amount. Certain types of other investments, such as Treasury Bills offer the full backing of the US Federal Government. Because these investments are virtually risk free, the interest rates on these investments are called the Risk Free Premium. This represents the amount our money can earn while avoiding our taking any risks. Hence we have the term ‘risk management by avoidance’.

If the risk free return is, for example 8 percent, then it would be unwise of us to invest our money in a risky investment where the expected yield would be only 8 percent or even 10 or 12 percent when we can invest our money at 8 percent without assuming any risk at all.  In fact, to make a risky investment attractive, it may have to offer us the possibility of 20 or even 30 percent return. The difference between a Risk Free Return and the return on a risky investment is called the Risk Premium. This is the amount of money an investor hopes to make from taking on a risk. 

The risk-return trade off is one of the most important principles in finance. In simple terms, it states that an investor must be paid to take on risk.

When statistical measures are used to evaluate stocks, the Capital Market Line is used to measure the required return for a given amount of risk.

Capital Market Line
Capital Market Line

The line begins at zero risk and the amount of return on zero risk investments such as treasury bills or FDIC insured bank accounts. This statistical model assumes that the relationship between risk and return is a linear one. The higher the expected risk, the higher the required return, and conversely, the higher the expected return, the higher the likely risk for the investor. 

The expected return for a risk factor of 1.0 would be 12 percent according to this graph and the expected return for a risk factor of 1.7 would be around 17%.

Diversification

Diversification relies upon the law of large numbers to reduce the average loss or gain.  If investors have stock in one company, and the company runs into hard times, the investors may loose all their investment. So investors would diversify their investments across various industries such as food, transportation, manufacturing, and energy.

If an investor has several different types of investments, he or she can absorb the loss in one or more investments and still make profit over the long term. Loss from one investment is offset by gains from other investments. Investors may further manage risk by diversifying their investments in combinations of stocks which tend to go up and down in ways which offset the risks of each individual stock. For example, High oil prices may cause oil companies stocks to rise and a trucking company’s stocks to fall. Investors may choose to buy both stocks to offset the risk of any one investment. 

Consolidation

Risk may also be managed through consolidation.  Consolidation is the grouping of a large number of statistically similar cases together.  This method is a commonly used by insurance companies.  For a company offering life insurance, the likelihood of a single individual living less than or more than the average life expectancy is not measurable, because the behavior of a single individual cannot be predicted from statistics.  However the life expectancy of a large group of insurance holders will conform to statistical models.  The insurance companies can manage their finances according to statistics which apply to the group of clients as a whole.

Specialisation

Another tool of risk management is specialization. For example, specialists, convert uncertainties to a measured risk by grouping on the basis of similarities.  The specialist in a stock is, by definition, a risk-taker, that prices the unique risk of buyers and sellers by maintaining a market in the security. 

The specialist’s risk is mini­mized by specialization, their understanding of the market, access to information regarding limit orders, trading volume, and their privileged position, and their market making monopoly in the security.

Quantative Theory

Using these basic ideas, we will now turn our attention to a quantitative theory used to construct investment portfolios. Modern Portfolio Theory is a fundamental theory about market behavior used by investment professionals around the world.  In my next article we will take a detailed look at the Modern Portfolio Theory.

Comments

    0 of 8192 characters used
    Post Comment

    • profile image

      Chubby 

      3 years ago

      That's a smart way of thnkniig about it.

    • profile image

      Mercedes 

      3 years ago

      Really well written post for Link Building. Guest pstiong is quite essential part of blogging and the best way to boost your link building is through guest blogging only. in guest blogging there are chances that the blog owner allows you to insert one link within the post and one in author bio.Thank you for providing this great post Jeet Dholakia recently posted..

    • Global-Chica profile image

      Anna 

      7 years ago from New York, NY

      Thanks for the hub, it served as a great refresher!

    • one2get2no profile imageAUTHOR

      Philip Cooper 

      7 years ago from Olney

      Thank you for your comment.

    • htodd profile image

      htodd 

      7 years ago from United States

      Great hub,Thanks

    • skgrao profile image

      S K G Rao. 

      8 years ago from Bangalore City - INDIA.

      Please mention Courtesy - WIKIPEDIA in your Bell Curve.

    • one2get2no profile imageAUTHOR

      Philip Cooper 

      8 years ago from Olney

      Thank you very much for your comment. I hope they learn from it.

    • Bilaras profile image

      Edward Happer MSc 

      8 years ago

      Ill recommend this article to my students because i think its very comprehensive and nicely written. Great work keep writing.

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, hubpages.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: https://hubpages.com/privacy-policy#gdpr

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)