When you are investing, you are exposing yourself to a variety of risks – some of which you can foresee, characterize and even try to estimate in advance. This gives you an advantage because you can prepare and find ways to protect yourself. But others will inevitably be unpredictable and maybe impossible to quantify in advance. That is why you need to use investment strategies that offer sufficient diversification that is compatible with your risk tolerance.

The content of this post does not constitute financial advice. It is intended for educational purposes only.

Investing and Risk

No investment is without risk. Certain types of risks can be mitigated, minimized, or in some cases maybe eliminated, but some types of risks always remain. For instance, treasury securities of AAA-rated government issuers are generally considered by many as a “risk-free asset”. But that is due to low or virtually zero default risk, which does not apply to every high-rated government. But even if we accepted that to be the case, they would still carry rating migration risk (i.e. the government issuer can be downgraded, causing credit spreads to rise and treasuries to lose value), reinvestment risk (i.e. the risk that yields move lower, meaning the coupons will be reinvested at lower rates), market or interest rate risk (i.e. yields move higher, causing bond values to drop), etc.

The point is, there are many aspects of an investment, not merely its price fluctuations and the most obvious drivers of them. The structure and nature, the investment vehicle or account provider, the behavior of the investor, the amount of leverage taken on, the macro environment… all these (and more) can lead to risks beyond the most visible attributes of a financial instrument. That is why, risk management is overall a complex topic and many individual investors struggle with it, might not fully comprehend it or could outright ignore it.

SIX KEY benefits of a risk management habit

The process of managing risks in your investment portfolio could seem tedious and time-consuming. It may very well feel like a distraction and, in fact, there are many advisors and coaches out there who would advise you to “set and forget” and not worry about anything but adding positions to your portfolio and ignoring everything else. I am convinced that this is a very risky and even damaging approach to one’s skills as an investor. Because, at the end of the day, investing is not much more than assuming risks, understanding risks, avoiding risks, transferring risks, balancing risks… essentially, a ‘game’ of risk – calculated risk that enables commensurate reward.

Developing and following a strategy or at least a simplified framework for risk-managing your investments, can have the following benefits for the individual investor:

1. You will be able to understand where your exposures are, break them down, and figure out which market factors or macroeconomic or firm-specific variables could drive current or future fluctuations in your positions. This gives you a considerable edge – because you may want to dispose of some of those that you will not be able to tolerate while keeping others that are more to your liking. For example, you might have asset classes in your portfolio, which, in an environment of significant inflation and high interest rate volatility, have become much more volatile than you are willing to accept.

2. You will know whether your risk-adjusted return is appropriate. Including when adding new positions to your portfolio. For instance, one popular measure of risk-adjusted return is the Sharpe ratio (excess return over the risk-free rate, per unit of standard deviation; note – this is not a suitable measure for every type of investment or portfolio). An investment earning a 12% annual return with a standard deviation of 10% has a higher non-adjusted return compared to an investment earning 10% annually but having a standard deviation of only 7%. However, assuming a 3% risk-free rate, the latter has a higher Sharpe ratio (1 = (10% – 3%)/7%) compared to the former (0.9 = (12% – 3%)/10%) – i.e., you get a higher return per unit of standard deviation.

3. You can always keep track of whether your portfolio is getting too concentrated. By reviewing, and evaluating your exposures and monitoring them on a regular basis, you ensure that you always know whether you are becoming too exposed – to some single names, countries, economic groups, individual currencies, asset classes, sectors/industries, business models, etc.

4. Analysing risk types and risk drivers allows you to anticipate the possible impacts of adverse moves under various types of stress market environments. Economies and markets constantly evolve through cycles, and each stage of these cycles is characterized by certain changes in the macro variables and financial markets. If you think of various scenarios about the direction in which various asset classes have gone or could go in the future (not predict or forecast, just brainstorm in multiple directions and magnitudes), then knowing your exposures and sensitivities to the main variables/risk factors will enable you to understand or at least get an idea about the maximum losses you are likely to experience and prepare accordingly for such scenarios so you can minimize those losses. Your very own stress test.

5. You will be better able to target your exposures. Knowing what you can tolerate and what your return and volatility goals are, in combination with a full breakdown of your portfolio’s risk factors and sensitivities, allows you to make finer adjustments in what you want to take on (e.g., in order to get a higher return or specific sets of cash flows, or access to liquidity, etc.) and what you don’t.

6. Choose your protection or alternatives. Once you build the habit of looking at risk types and factors, and you understand those dimensions for your portfolio, you can be more precise in selecting the kind of risk mitigant that matches your goal and tolerance – whether that be insurance, some type of a hedge, an inflation-indexed instrument, etc. If you want to retain a certain exposure to a given risk factor but remove other risks a particular instrument carries (e.g., low liquidity), then your risk analysis could reveal investment alternatives that allow you to do that, whose risk profiles align more with your tolerances.

how to identify your risks

Generally, financial advisors and analysts would be able to support you in this process. If you are doing it on your own, then think about the following when trying to identify the risks in your investment portfolio (you can use the above chart with an example typology of risk types as a starting point):
– bottom-up review: think about the dimensions of your portfolio (asset classes, companies, countries, currencies, sectors, etc.) and assign each instrument/position a value for each dimension; the dimensions will almost immediately map to some type of risk in the chart above or a geographical location that could potentially be linked, for instance, to some sort of geopolitical risk
– top-down review: consider whether you are overly exposed (concentrated) within the full portfolio, with respect to any dimension you have looked at; analyze the existence of common risk factors or drivers across the dimensions
– beyond the obvious: think about extremes and things you have not seen or have happened extremely rarely (pandemics, global market crashes or financial crises, global natural disasters, global wars, etc.) – this kind of brainstorming would allow you to anticipate the so-called tail events or risks, which almost never occur, but when they do – the losses can be extremely severe (and even wipe you out).

practical steps for your portfolio

This is a list of steps you can take, in no particular order, as all of them can be key to protecting your portfolio effectively. Keep in mind that these steps would usually come after analysis and identification of risks, and some relate in particular to the setup of your investment account, as that can also result in more severe losses for you.

1. Limit setting – you can set absolute or relative limits for the size of your exposures (individual or by dimension identified per the guidance in the earlier paragraph) that align with your goals and tolerances. These can also be concentration limits or just thresholds you feel can allow you to better control/limit your losses over time or across different market environments (e.g., including under milder and more severe stress). The limits should not be set and forgotten but should evolve with changes in your circumstances, tolerance, goals, and portfolio.

2. Stop losses – you can set a level of loss for each position, to be sure it will be closed before the loss exceeds your tolerance and becomes too large to handle. This knife, however, has two edges – if a position is dropping significantly because the fundamentals truly warrant that, closing it could be the correct move, but if it is dropping due to a temporary change in sentiment or risk appetite in the markets, then you would realize a loss that could actually be recovered if you wait out the turmoil. For most individual investors, this is very difficult to know in advance, so you must exercise some judgment.

3. Leverage setting – depending on the broker and the instrument, you could set your leverage by default when you open the account, or later for each position you open individually. Leverage allows you to trade on margin, meaning you trade partly with your own equity and partly with borrowed money, which has to be repaid with interest to the broker. It therefore magnifies returns – meaning, both profits AND LOSSES will be bigger than if you traded the same amount entirely with your own equity. This increases the risk of your position (and its cost – as interest is charged for holding positions overnight). Why? Because the move that is needed in the instrument you are trading to trigger a margin call or wipe out your equity is much smaller. For instance, with a 100% equity trade, in order for the position to go to zero, there needs to be a 100% drop in its value (assuming no other costs and zero bid-ask spread), but some online brokers allow you to open positions with just 2% equity – which could very well be a move that some assets experience once per day or week.

4. Diversify – and that across several of the dimensions mentioned above. Being highly concentrated on any of them is too high a risk for individual investors. But of course, diversification has to be in line with personal risk tolerance and goals, so it may not be suitable for everyone, at least it may not be across every single dimension.

5. Behavior and psychology – controlling biases, avoiding emotional decision-making, panic and fear of missing out (FOMO) is a cornerstone of successful investing that doesn’t have to do that much with the portfolio but with the individual. In times of market stress and rapid changes in asset prices, people get scared and often don’t react rationally. But if volatility scares you off into an irrational mistake, your losses could grow significantly. This is something you can hardly teach, it is rather a skill to be developed by holding your portfolio persistently and with discipline across different environments and learning when is the right time to act or NOT to act.

6. Hedge or insure – take positions in other instruments that could profit when the main position loses in value as they are negatively correlated with them. This could be achieved through various derivatives and other instruments, as long as the investor understands them and the additional risks they carry. Insurance against certain events or types of losses is another option. Note that some of these options require a certain degree of sophistication or availability.

conclusion

Risk management is a core element of investing. Every investment carries exposure to risk types and risk factors and understanding those is at the center of successfully finding the right balance of risks within a portfolio that allows investors to meet their goals and respect their risk tolerances. In this post, we talked about multiple tangible benefits of the risk management process and some ways to identify risks and practically address some of them. Relying on a static portfolio structure for long-term investing without analyzing and regularly reviewing and measuring risks, respectively without correspondingly mitigating them, is likely to result in sub-optimal performance or exposures beyond an individual’s risk tolerance.