What is risk management?

Risk is a fundamental aspect of investing, closely tied to potential returns and commonly assessed through "volatility." However, this relationship is not always straightforward. Understanding risk is essential for any investor, as volatility represents just one dimension. For instance, a stock with low volatility might still carry significant risk if the company faces challenges, while a highly volatile stock could prove to be a safe long-term investment if its fundamentals are strong. If you are a beginner investor, this article will provide clear and practical insights into mastering risk management.

What is Risk Management?

Risk can be defined as the probability of suffering a loss or not achieving the expected return. Put simply, it is the uncertainty regarding the future outcome of an investment.

Risk in Stock Market Investing

Here’s a practical example: Imagine you invest €1,000 in company ABC's stocks, aiming for their value to rise so you can sell them at a profit. However, there’s also the possibility that the stock price might drop, resulting in a loss. This potential for loss is what defines risk.

A key principle in finance is that the potential return of an investment is generally proportional to its level of risk. In other words, the riskier an investment, the higher its potential return. Let's compare two investments:

1. A savings account with a 1% annual return. The risk is very low (or even zero if the amount is covered by deposit insurance), but the return is relatively low. 

2. Stocks with the potential to deliver (=yield) a 10% annual return but carrying a 20% chance of losing capital. Here, the potential return is much greater, but so is the associated risk!

This relationship exists because investors expect to be compensated for taking on risk. They will only accept high risk if the potential return is attractive. Of course, this is not an absolute law.

Some investments may provide lower returns than their risk level would typically suggest. In practice, actual returns can deviate significantly - either positively or negatively - from the expected returns.

What is the Link Between Risk and Volatility?

Volatility is commonly used to measure risk, as it reflects the extent of price fluctuations of a financial asset. To illustrate this, let's compare two stocks:

• Stock A fluctuates between €90 and €110 over the year

• Stock B fluctuates between €50 and €150 over the same period

Stock B is more volatile and therefore quite logically considered riskier. Its strong variations make the investment outcome more uncertain.

However, volatility captures only one aspect of risk. A stock with low volatility can still be risky if the company is in trouble. Conversely, a highly volatile stock in the short term can be a safe investment in the long term if the company's fundamentals are good.

High-Risk vs Low-Risk Assets: Concrete Examples

Examples of high-risk assets:

• Emerging market stocks: Stocks of companies based in developing countries (Brazil, India, China...) are usually considered risky. These economies experience rapid growth but are more vulnerable to economic, political and monetary shocks. Corporate governance and transparency standards are often less developed than in mature markets.

• Cryptocurrencies: Assets like Bitcoin are volatile and speculative. It's not uncommon for them to gain or lose 20% of their value in a single day. Regulation of this market is still a work in progress.

• Options and derivatives: These complex financial instruments, which allow for betting on the future evolution of an asset, offer high returns but carry a risk of total loss of invested capital.

Examples of low-risk assets:

• Government bonds: When you purchase a government bond, you're essentially lending money to a government. For countries like the United States, France, or Germany, the risk of default is considered extremely low. In exchange, the return (=yield) is relatively modest.

• Money market funds: These funds invest in short-term (less than one year) debt securities issued by governments or top-tier companies. Their objective is to preserve capital, at the cost of low returns. The risk is not zero, but it is very limited!

Why measuring risk is a complex task for new investors

The first reason lies in understanding risk factors. Each asset class is exposed to different types of risk (economic, political, interest rate, exchange rate, …). It can be difficult for a beginner to identify and assess all these factors. For example, few investors predicted the risk of a global pandemic before the Covid-19 crisis.

The second reason is the difficulty in accessing and interpreting data. To measure risk, one must analyze a lot of data (company financial statements, economic statistics, ...). This information is not always easy to obtain or understand for a non-professional.

The third reason is psychological biases. Our emotions can distort our perception of risk. For example, we tend to underestimate the risk of investments that have been successful for us in the past (this is the confirmation bias) or to overestimate our ability to "beat the market" (overconfidence bias).

What is risk appetite?

Risk appetite can be defined as the level of risk an investor is willing to accept in pursuit of their investment goals. It is a highly personal concept, influenced by factors such as your financial situation, investment timeline, objectives and even your psychology or emotions.

Let's take the example of two investors, Alice and Bob, who each have €100,000 to invest:

• Alice is 30 years old, has a stable and well-paid job, and is saving for retirement. She is comfortable with the idea that the value of her investments may fluctuate strongly in the short term, because she knows she has time to recover from potential losses. Her risk appetite is high.

• Bob is 60 years old, retired, and relies on his investments to boost his pension. He needs stable income and cannot afford to lose a significant part of his capital. His risk appetite is low.

Based on their risk appetite, Alice and Bob will adopt very different investment strategies:

• Alice will invest a large part of her portfolio in stocks, potentially in riskier but promising sectors or geographies (technology, emerging markets, ...). She accepts high volatility in exchange for potentially higher returns.

• Bob will favor less volatile investments such as government bonds, money market funds or maybe a moderate share of large stable companies' stocks. His primary goal is to preserve his capital, even if it means only modest returns.

We can see here that risk appetite determines investment choices. And this is where the link with risk management becomes clear. The first step in good risk management is therefore to determine one's own risk appetite. It is the starting point that will guide your entire strategy. If you invest without considering your risk appetite, you could end up in uncomfortable situations:

• If you take more risk than you can bear, you may panic and sell at the wrong time in the event of a market downturn, turning potential losses into real losses.

• Conversely, if you are too cautious in relation to your goals and investment horizon, you may not generate enough return to achieve your long-term financial goals.

Risk appetite is not set in stone. It can evolve over time, depending on your situation and experiences. But at every moment, it must serve as a compass to guide your decisions and your risk management.

Risk management and the concept of standard deviation

Now, let's explore a more technical yet essential aspect of risk management: standard deviation and its role in illustrating volatility. Standard deviation is a statistical tool that measures how much a set of data points varies from their average. In investing, it is used to assess the historical volatility of a financial asset, reflecting the extent of price fluctuations over time.

Let's take a concrete example again. Imagine two stocks:

• Stock A had the following annual returns over the last 5 years: 5%, 7%, 4%, 6%, 8%. The average is 6%.

• Stock B had the following returns: -10%, 20%, -5%, 25%, 10%. The average is 8%.

Calculating the standard deviation reveals a significantly higher value for stock B. This indicates that the returns of stock B were much more spread out around the average, meaning stock B was more volatile.

Why is this important for an investor? Because volatility is a measure of risk. The more volatile an asset, the riskier it is considered. Let's go back to our two stocks. Over 5 years, they have the same average return of 8%. But an investor who would need their money at a given time would have had a greater chance of suffering a loss with stock B, due to its higher volatility.

This is where risk management comes in. By looking at the historical standard deviation of an asset, an investor can get an idea of its volatility and thus the risk it represents. They can then decide if this level of risk is compatible with their own risk appetite and financial goals.

What are the potential consequences of failure in risk management for investors?

As we have seen, every investment involves risk. Even assets considered the safest, such as government bonds, are not entirely risk-free. The objective of risk management is not to totally eliminate risk, but to understand it, quantify it and keep it at an acceptable level.

If you fail at this task, you are indeed exposing yourself to very real losses. "Losing money" can be a vague notion, so let's look at some very concrete scenarios:

• Overexposure to an asset or sector: Imagine that, inspired by the strong performance of the technology sector, you decide to invest 80% of your portfolio in stocks of this sector. This is a typical case of excessive risk concentration. If the tech sector were to suffer a major setback (as during the bursting of the internet bubble in 2000), the value of your portfolio could drop dramatically, by 50% or more. Good risk management would have led you to diversify your portfolio across different sectors.

• Exchange rate risk in emerging markets: Suppose you decide to invest in Brazilian corporate bonds, attracted by their high yields. You are then exposing yourself to exchange rate risk: if the Brazilian Real were to depreciate significantly against the Euro, the value of your investment could decrease, even if the companies remain financially stable. This risk became a reality for many investors during the emerging currency crises of the 1990s and 2000s.

• Liquidity risk: Let's say you invest a significant portion of your portfolio in real estate. If you suddenly need money (job loss, health problem, ...), you might be forced to sell these assets in a hurry and at a loss. This is liquidity risk. Prudent risk management involves always keeping a portion of your portfolio in highly liquid assets, even if it means accepting a low return.

• Interest rate risk: If your portfolio is mainly invested in bonds, a large and sudden increase in interest rates ccould lead to a significant drop in the value of your securities. This is what many investors experienced during the "Great Bond Massacre" of 1994.

Clearly, the consequences of poor risk management can be very concrete and painful: severe capital loss, lack of liquidity at the wrong time, returns wiped out by exchange rate or interest rate movements. In extreme cases, it will jeopardize your long-term goals, such as your retirement or your children's college funding.

What is risk treatment?

Once a risk has been identified and assessed, there are mainly four ways to treat it.

Accept the risk

Suppose you invest in an equity fund. You know there is a risk of markets falling in the short term, but you accept it, because your investment horizon is 10-15 years and you anticipate an attractive return over the duration.

This consists of consciously accepting the risk, without seeking to modify it. This strategy is justified when the cost of managing the risk would be greater than the potential impact of the risk itself.

Transfer the risk

When you purchase a put option on a stock you own, you shift the downside risk to your counterparty. If the stock price drops below a certain level, you have the right to sell your shares at a predetermined price, thereby limiting your potential loss.

This approach involves transferring the risk to another party, typically for a fee. Insurance is a common example of risk transfer.

Avoid the risk

Suppose you are considering investing in bonds of an emerging country, but after an analysis, you feel that the political and exchange rate risks are too high. You finally decide not to invest in this country at all. You have avoided the risk.

This involves modifying your behavior or strategy to completely eliminate your exposure to the risk.

Reduce the risk

Diversification is a classic method of risk reduction. By spreading your investments across different assets, sectors and geographical areas, you reduce the specific risk of each investment. If one asset performs poorly, its impact on your overall portfolio would be limited.

This is ultimately the most common strategy. It aims to reduce the probability and/or impact of the risk to an acceptable level.

These strategies are not mutually exclusive. For the same risk, you can combine several approaches. For example, you can decide to accept the general market risk (because you believe in the long-term performance of stocks), while reducing the specific risk to each stock through diversification. Additionally, you could transfer the risk of a market crash by purchasing put options on part of your portfolio.

Risk management techniques and strategies

Diversification

As we have seen, this is one of the fundamental strategies. It involves spreading one's investments across different assets, sectors, geographical areas, etc. The idea is that if one element of the portfolio performs poorly, it would be compensated by the good performance of other elements. We have an entire article dedicated to diversification techniques.

Example: Instead of investing all your money in the stock of a single company, you spread your investment over numerous stocks, bonds, real estate funds, etc.

Asset allocation

This is the process by which you divide your money among the major asset classes (stocks, bonds, cash, real estate, etc.) according to your goals, your investment horizon and your risk appetite.

Example: A young investor with 15-20 years ahead of him could have an allocation of 80% in stocks and 20% in bonds, while an investor close to retirement could have 40% in stocks, 50% in bonds and 10% in cash.

Regular investing (or Dollar-Cost Averaging)

Instead of trying to find the "best time" to invest, you invest a fixed sum at regular intervals. This approach can help to achieve an average purchase cost over time. Find more information on cost averaging here. 

Example: You invest €1,000 in a fund every month, regardless of market performance.

Portfolio rebalancing

Over time, the performance of different assets can cause your asset allocation to deviate from its initial target. Rebalancing involves periodically adjusting your portfolio to return to your initial allocation.

Example: If after a year, the strong rise in stocks has brought their weight to 85% of your portfolio instead of the targeted 70%, you sell some stocks to buy bonds and return to 70/30.

Safe haven assets

These are assets that tend to perform well during periods of economic or market turbulence. They can help stabilize a portfolio.

Example: Gold is often considered a safe haven. During the 2008 financial crisis, while many stocks were falling, the price of gold rose.

Risk/Return analysis

Before investing, it is important to evaluate both the potential return and the risk of an asset. Tools like the Sharpe ratio allow you to compare the excess return of an asset relative to its risk.

Example: Between two funds with the same average return, you would choose the one with the lowest volatility (and therefore risk).

Stress testing and scenario analysis

This involves simulating how your portfolio would behave under different market conditions, including crisis scenarios.

Example: You could test how your portfolio would have performed during the 2008 crisis, or simulate what would happen if interest rates suddenly rose by 2%.

Again, these different strategies are not mutually exclusive and are combined in practice. Everything relies on your thoughtful and disciplined approach to risk management.

Conclusion

What we must remember from all this is that risk is inherent to all investment. There is no return without risk. The goal is not to eliminate risk, but to manage it intelligently. To this end, diversification is a pillar of risk management. By spreading investments, we reduce the specific risk to each asset, exactly as the saying goes: "Don't put all your eggs in one basket."

Risk has several dimensions. There is the general market risk, but also risks on a more specific scale: exchange rate risk, interest rate risk, liquidity risk, etc. All these risks are obviously quantifiable, using a statistical toolbox that includes standard deviation or the Sharpe ratio. But be careful, these measures have their limits and do not always capture extreme risks (the "tails of the distribution").

Risk is not a fixed data point. Market conditions, economic and regulatory environments, etc/ are constantly changing. What was considered safe yesterday can become risky tomorrow, and vice versa. For these reasons, risk management is not an absolute guarantee against losses. But without it, one is exposed to potentially much heavier and more lasting losses. It’s similar to a seat belt: it doesn’t prevent accidents, but it helps minimize the damage.

Finally, risk management is a discipline that is learned and requires practice. It's not always easy, especially when markets are turbulent and our emotions take over. It is precisely during these moments that risk management proves to be most valuable.