Implementing a risk management process is an essential part of successful investment management. The reason most investors have been unsuccessful is because they do not have a risk management process which addresses the risks that sabotage their portfolios.
Many investors have employed a simple buy and hold strategy that has destroyed wealth and set back their retirement plans a decade or more. Remember, a 50% loss requires a 100% gain to breakeven. A 10% loss only requires an 11% gain to get back to breakeven.
Risk Management Process
Risk management requires:
Identify potential risks.
Develop risk management solutions.
Manage risk by choosing a path or technique to optimize the risks (minimize) and rewards (maximize) of the portfolio.
Identify Potential Investment Management Risks
The two major investment management risk categories to identify are systematic risk and unsystematic risk. Systematic risk is risk associated with market returns. These are risks that are affected by macroeconomic factors that affect the market as a whole. These risks would include changes in interest rates, inflation, recessions, war, etc. Unsystematic risk is company specific or industry specific risk. This is risk specific to the individual investment or small group of investments and is uncorrelated with stock market returns.
Develop Risk Management Solutions
Once identification and assessment are completed, there are 4 major risk management solutions:
Avoid – eliminate or withdraw from investment choices.
Control – mitigate or optimize through action.
Transfer – outsource through hedging or insurance
Accept – make the investment knowing the risks
Avoiding and accepting risks are fairly straightforward decisions. The other two decisions, control and transfer, require further decision making.
Investment Management Risk Solutions
First priority should be to mitigate unsystematic (specific risk) because it is the easiest and offers the largest benefits of investment risk management. Diversification is frequently described as a “free lunch” because it has the ability to lower risk without lowering returns.
The purpose of investment diversification is holding a variety of non-correlated assets which can nearly eliminate unsystematic risk. If a portfolio consists of just a few stocks the entire portfolio can suffer severe damage if one stock experiences a large decline. However, a portfolio that consists of many stocks would suffer minimal damage from the decline of one stock.
Control Market Risk Management
Market risk (systematic risk) management is not quite as easy to mitigate or control. Some investors may choose hedging strategies; others may choose to partially control market risk by increasing their asset allocation to fixed income or cash.
As Portfolio Manager of the Arbor Asset Allocation Model Portfolio (AAAMP) I employ an active or tactical asset allocation strategy. This allows me the flexibility to change my asset allocation depending on valuations. This has been an effective strategy because valuation, more than any other factor, determines long term risk and returns. If you invest when valuations are high your long term returns will be below historical averages. If you invest when valuations are low your long term returns will be higher than average.
My risk management process has been to identify the two most important risks to a portfolio and develop risk management solutions. Specifics or unsystematic risk can be mitigated by diversification. Market or systematic risk can be controlled by hedging and using a tactical asset allocation strategy based on valuation.
Related Reading: Perceived Risk vs. Real Risk: A Key to Successful Value Investing