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What is Risk Management?

Risk management occurs everywhere in the realm of finance. It occurs when an investor buys U.S. Treasury bonds over corporate bonds, when a fund manager hedges his currency exposure with currency derivatives, and when a bank performs a credit check on an individual before issuing a personal line of credit. Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio and investment diversification to mitigate or effectively manage risk.

How Risk Management Works

We tend to think of "risk" in predominantly negative terms. However, in the investment world, the risk is necessary and inseparable from the performance.

A common definition of investment risk is a deviation from an expected outcome. We can express this deviation in absolute terms or relative to something else, like a market benchmark. That deviation can be positive or negative, and it relates to the idea of "no pain, no gain": to achieve higher returns, in the long run, you have to accept the more short-term risk, in the shape of volatility.

How much volatility depends on your risk tolerance, which is an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short-term losses.

• Risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.
• isk is inseparable from return in the investment world.
• A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statistical measure of dispersion around a central tendency.
• Beta, also known as market risk, is a measure of the volatility, or systematic risk, of an individual stock in comparison to the entire market.
• Alpha is a measure of excess return; money managers who employ active strategies to beat the market are subject to alpha risk.