Investments that promise ultra-high returns tend to come with higher risk, potentially causing losses beyond your risk tolerance. Effective risk management is therefore fundamental to a solid portfolio strategy. Your goal as an investor should be to manage risk prudently and not eliminate it entirely.
What Do We Mean by Risk?
Risk is fundamentally about uncertainty. The higher the risk, the lower the certainty of achieving the expected return. Investors must always weigh potential risk against potential reward in any decision.
Government bonds denominated in its domestic currency are often considered “risk-free”. The promised coupon payment is practically 100% guaranteed as the issuing government can simply print the money to meet its obligations.
On the other end of the risk spectrum is, for example, a technology start-up raising capital. If it becomes the next Facebook, the returns could be exponential, but the likelihood of a loss is very high.
Types of Risk
Risks fall into many categories and the list below is by no means comprehensive. Some broad risks affect the entire market.
Market Risk
Market risk is the possibility of loss due to factors that affect the overall financial market performance (for example, a sudden drop in investor confidence).
Interest Rate Risk
Interest rate risk is the possibility that a change in interest rates would reduce the value of bonds or other fixed-rate investments.
Event Risk
Event risk is the possibility of loss due to unforeseen events, such as war or natural disasters.
Other risks are specific to a particular company, sector, or product.
Credit Risk
Credit risk is the possibility that a borrower or counterparty cannot meet their financial obligations when due.
Legal Risk
Legal risk is the possibility of financial loss due to legal actions, such as lawsuits or regulatory penalties.
Prepayment Risk
Prepayment risk is the possibility of reduced returns on bonds or loans if the borrower repays early or the bond is called before maturity.
Liquidity Risk
Liquidity risk is the possibility of loss when you must sell an asset urgently in a thin market (few buyers), potentially forcing a price well below fair value.
The list of risks is virtually endless, and the relevant risk factors depend on your exposure to specific industries, companies, asset classes, and geographies.
The Four Elements of Risk Management
While risk management is a complex endeavor, it consists of four basic steps:
Understand
The first step in risk management is to understand the risks, both external and internal, to which your investment portfolio is exposed. Some risks apply to all investors, while others are specific to where and how your capital is deployed. It is also important to understand your personal risk tolerance level (i.e., your willingness and financial ability to take on risk) and manage the portfolio accordingly.
Monitor
The next step is to identify the data pertaining to the key sources of risk. This could be publicly available economic data or a private database by a commercial enterprise. In some cases, certain data must be estimated based on expert opinion.
Measure
The collected data must then be measured and synthesized into an ongoing quantitative assessment of how the portfolio’s key risks are evolving, and whether they remain within acceptable limits. This may include periodically estimating prices for illiquid holdings, where no market price is available. The calculated risk levels should be evaluated against the investor’s risk appetite, with rebalancing undertaken if the risk exceeds that appetite.
Hedging
Certain risks can be mitigated through hedging instruments (for example, offsetting a long position with a short position, buying put options to limit the downside of holding a stock, converting a floating-rate loan to fixed-rate loan through an interest rate swap, using currency options and forwards to mitigate exposure to foreign currencies). However, hedging is not free. Its cost can lower returns, therefore the risk manager must carefully evaluate and choose an optimal hedging strategy.
Conclusion
Risk is unavoidable and inextricably linked to return. Seeking only “safe” investments to minimize risk may not create sufficient returns to meet your goals. Effective risk management is about optimizing risk and return within the risk tolerance.
Having a trusted professional wealth manager, who optimizes your risk-adjusted returns and safeguards against major risks, is clearly an advantage.
About David M. Darst, CFA
Since January 2017, David M. Darst, CFA has served as Senior Advisor and Investment Strategist of The Family Office in New York and Bahrain. In this role, he has significantly contributed to the formulation, communication, execution, and monitoring of the company’s asset allocation, investment strategy, and wealth management activities in the Gulf region, North America, Europe, and Asia.
Following a 25-year career with Goldman Sachs in Zurich and New York, David served for 17 years as a Managing Director and Chief Investment Strategist of Morgan Stanley Wealth Management. David was the founding President of the Morgan Stanley Investment Group, and has served for three years as CEO of Petiole Asset Management AG, the Zurich-based asset management arm of The Family Office.
David is the author of sixteen books, including The Complete Bond Book (McGraw-Hill), The Handbook of the Bond and Money Markets (McGraw-Hill), The Art of Asset Allocation, Second Edition (McGraw-Hill) and The Little Book that Saves Your Assets (John Wiley & Sons), which has been ranked on the bestseller lists of The New York Times and Bloomberg Business Week.
Disclaimer
This presentation is provided to you by The Family Office Co. BSC(c) (“The Family Office”) for informational purposes only, and contains proprietary information that may not be reproduced, distributed to, or used by, any third parties without The Family Office’s prior written consent.
All information, figures, calculations, graphs and other numerical representations appearing in this presentation have not been audited and may be subject to change over time. Furthermore, certain valuations (including valuations of investments) appearing in this presentation are subject to change as they may be based on either estimates or historical figures that do not reflect the latest valuation. Although all information and opinions expressed in this presentation were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to their accuracy or completeness. The information contained herein is not a substitute for a thorough due diligence investigation. Past performance is not indicative of and does not guarantee future performance. Exit timelines, prices and related projections are estimates only, and exits could happen sooner or later than expected, or at a higher or lower valuation than expected, and are conditional, among other things, on certain assumptions and future performance relating to the financial and operational health of each business and macroeconomic conditions.
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