A:

Risk management is a crucial process used to make investment decisions. The process involves identifying the amount of risk involved with an investment, and either accepting that risk or mitigating it. Some common measures of risk are standard deviation, beta, value at risk (VaR) and conditional value at risk.

Four Risk Management Measures

Standard deviation measures the dispersion of data from its expected value. The standard deviation is used in making an investment decision to measure the amount of historical volatility associated with an investment relative to its annual rate of return. It indicates how much the current return is deviating from its expected historical normal returns. For example, a stock that has a high standard deviation experiences higher volatility, and therefore, a higher level of risk is associated with the stock.

Beta is another common measure of risk. Beta measures the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market. The market has a beta of 1, and it can be used to gauge the risk of a security. If a security's beta is equal to 1, the security's price moves in time step with the market. A security with a beta greater than 1 indicates that it is more volatile than the market. Conversely, if a security's beta is less than 1, it indicates that the security is less volatile than the market. For example, suppose a security's beta is 1.5. In theory, the security is 50% more volatile than the market.

Value at risk (VaR) is a statistical measure used to assess the level of risk associated with a portfolio or company. The VaR measures the maximum potential loss with a degree of confidence for a specified period. For example, suppose a portfolio of investments has a one-year 10% VaR of $5 million. Therefore, the portfolio has a 10% chance of losing more than $5 million over a one-year period.

Conditional VaR is another risk measure used to assess the tail risk of an investment. Used as an extension to the VaR, the conditional VaR assesses the likelihood, with a certain degree of confidence, that there will be a break in the VaR; it seeks to assess what happens to an investment beyond its maximum loss threshold. This measure is more sensitive to events that happen in the tail end of a distribution – the tail risk. For example, suppose a risk manager believes the average loss on an investment is $10 million for the worst 1% of possible outcomes for a portfolio. Therefore, the conditional VaR, or expected shortfall, is $10 million for the 1% tail.

Categories of Risk Management

Beyond the particular measures, risk management is divided into two broad categories: systematic and unsystematic risk.

Systematic risk is associated with the market. This risk affects the overall market of the security. It is unpredictable and undiversifiable; however, the risk can be mitigated through hedging. For example, political upheaval is a systematic risk that can affect multiple financial markets, such as the bond, stock and currency markets. An investor can hedge against this sort of risk by buying put options in the market itself.

The second category of risk, unsystematic risk, is associated with a company or sector. It is also known as diversifiable risk and can be mitigated through asset diversification. This risk is only inherent to a specific stock or industry. If an investor buys an oil stock, he assumes the risk associated with both the oil industry and the company itself.

For example, suppose an investor is invested in an oil company and he believes the falling prices of oil affect the company. The investor may look to take the opposite side of, or hedge, his position by buying a put option on crude oil or on the company; or he may look to mitigate the risk through diversification by buying stock in, say, retail or airline companies. He mitigates some of the risk if he takes these routes to protect his exposure to the oil industry. If he is not concerned with risk management, the company's stock and oil price could drop significantly and he could lose his entire investment, severely impacting his portfolio.

RELATED FAQS
  1. What does Value at Risk (VaR) say about the "tail" of the loss distribution?

    Learn about value at risk and conditional value at risk and how both models interpret the tail ends of an investment portfolio's ... Read Answer >>
  2. How to calculate Value at Risk (VaR) in Excel

    Learn what value at risk is, what it indicates about a portfolio and how to calculate the value at risk of a portfolio using ... Read Answer >>
  3. What is the minimum number of simulations that should be run in Monte Carlo Value ...

    Find out how many simulations should be run at minimum for an accurate value at risk when using the Monte Carlo method of ... Read Answer >>
  4. What are some examples of risk management techniques?

    Understand what risk management is in business and why it is a necessary component of ongoing business planning, and review ... Read Answer >>
  5. What Is the Formula for Calculating Beta?

    Learn about beta, how to calculate it, and how it's used as a risk measure with examples that include Apple and Tesla. Read Answer >>
Related Articles
  1. Investing

    Value at Risk (VaR)

    Value at risk, often referred to as VaR, measures the amount of potential loss that could happen in an investment or a portfolio of investments over a given time period.
  2. Personal Finance

    Backtesting Value-at-Risk (VaR): The Basics

    Learn how to test your VaR model for accuracy.
  3. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  4. Investing

    An Introduction to Value at Risk (VAR)

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
  5. Investing

    6 Risks Threatening Your Portfolio Today

    Factoring in these risks is crucial when building a portfolio.
  6. Investing

    Beta: Know the Risk

    Beta says something about measuring price risk in stocks, but how much does it say about fundamental risk factors too?
  7. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? Here we teach you about standard deviation, beta and more.
  8. Investing

    Beta: Gauging price fluctuations

    Learn how to properly use this measure that can help you meet your criteria for risk.
  9. Investing

    3 Cases When Beta Does Not Measure Volatility of Stocks

    Examine the theoretical and statistical relationship between beta and volatility to identify three factors that limit beta's explanatory value.
RELATED TERMS
  1. Value At Risk - VaR

    Value at risk - VaR is a statistic that measures and quantifies ...
  2. Company Risk

    Company risk is the financial uncertainty faced by an investor ...
  3. Professional Risk Manager - PRM

    Professional risk manager is a designation awarded by the Professional ...
  4. Accepting Risk

    Accepting risk occurs when a business acknowledges that the potential ...
  5. Dispersion

    Dispersion is a statistical term that describes the size of the ...
  6. Price Risk

    The risk of a decline in the value of a security or a portfolio. ...
Hot Definitions
  1. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  4. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  5. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center