Risk management is engrained in our everyday life. From the decision to hit the snooze button in the morning to checking your social media updates, we're unconsciously risk managing our life. But, what about in investing, especially for DIY investors?
In this article, we challenge you to improve your ways of managing risk. In particular, we’ll discuss what risk management means in investing, how and why you should risk manage your investments and ultimately, what you can do today to kick-start your journey of improving risk-adjusted returns.
History and origins of risk management
A short trip down memory lane, here's a brief history and origins of risk management.
The concept of risk management is said to have originated from a gambler’s dispute in 1654, which led to the formation of probability theory by two famous French mathematicians, Blaise Pascal and Pierre de Fermat.
One of the early adopters of this concept came about when Edward Lloyd, an English (some say Welsh) merchant, opened his coffee house on Tower Street, London in 1686. “What does a coffee house have anything to do with risk management?” you might ask.
Well, the coffee house was much more than serving perfect English coffee with walnut cake to its patrons. In fact, it was an extremely popular hub among sailors, merchants, captains and ship-owners who would exchange maritime gossips and information.
Edward understood the importance of information to businesses and began collating information and insights on ships, cargo and weather events. It was these information that will later proved to be critical for insurance and managing risk.
Interestingly, one of the biggest worry among his coffee house patrons was the uncertainty of their ships not returning. For this reason, Edward found a solution by inviting investors who would be interested in selling insurance to its patron for an upfront premium.
One thing led to another, the coffee house soon turned into a common meeting place for the buying and selling of marine insurance. This cemented the foundation of modern day Lloyd’s of London. Fast forward to today, Lloyd’s continue to play a significant role in the global insurance and reinsurance market.
It was believed that the birth of Lloyd’s was the key catalyst to modern risk management practices we’re accustomed to today. Essentially, buyers (and sellers) of insurance are risk managing and hedging their businesses in the event of a loss. In short, insurance is perhaps the earliest real-life application of risk management.
What is risk management exactly?
In finance, the word “risk” is almost always linked with something negative. Naturally, financial risk management became analogous to avoiding risk altogether. We beg to differ. Risk management is as important (if not more) as choosing what stocks to buy itself.
So, what exactly is risk management? Because of the multifaceted approach to risk management, a good way of understanding is through its misconceptions.
Risk management isn't about minimising risk
Rightly said, AQR, a quant-driven investment manager, argued that the objective of risk management is to take the right amount of risk, of the right kind, at the right times. I’ve encountered many investment professionals who confuse managing with minimising risk.
Risk management works both ways, there’s an equivalent opportunity cost of taking too much and too little. Rather, a good way to think about this concept is on a risk-adjusted basis, which is expected return per unit risk. We’ll explore this in more detail below.
Risk management isn't about model spewing out random numbers
With today’s state-of-the-art risk management tools, are we more capable in managing risk than before? Yes and no.
The “yes” part relates to expanded field of risk that we haven’t considered in much detail before, eg: cyber and operational risk.
The “no” part, however, relates to more sophisticated models to analyse “risk”. While we have deep appreciation for risk models, a model is only as good as its assumptions. Models should inform, not decide.
The fascination of a one-number summary for risk has inadvertently driven some investors to game the system, defeating the purpose of risk management in the first place. Risk cannot be accurately measured. It can only be estimated.
Risk management isn't about predicting what will happen in the future
Another misconception about risk management is that predicting the future will do wonders to the way you risk manage your portfolio. While it’s a plus to be able to forecast future events accurately, robust risk management concerns having a plan before you need a plan. It's more about being aware of the situation you’re in today than the future.
Why is risk management important?
Risk management describes the process of evaluating internal and external risk and ways to mitigate them. Effective risk management won’t make you rich tomorrow, but it’ll sure help you generate greater risk-adjusted return. Consequently, this means making more by risking less.
Secondly, it encourages investors to think ahead and make plans in case of the unexpected. Notice I use the word unexpected, which can mean good or bad events. As a hedge fund portfolio manager, I have to constantly think about “what ifs”. For this reason, I am extremely clear of what I need to do given a situation. A good example is when the coronavirus crisis started during early Feb, I aggressively reduce my risk exposures by 40%!
Finally, risk management aligns investors’ objectives and risk appetite. For instance, an investor who aims for low volatility should not be going anywhere near cryptocurrencies. The beauty of the process is that it serves as a constant reminder of your risk profile. More importantly, risk management prevents unnecessary panic or emotional investing.
An interesting observation we have is risk management should be especially important for DIY investors because they have 100% skin in the game. This contrast with professional investors managing billions of dollars, many of whom have a much smaller % of their own invested in the fund.
So, how can we make use of risk management effectively to boost returns?
Type of risks investors should know
For DIY investors, the 3 types of risk we should be aware are market risk, specific risk and systemic risk.
Market risk refers to losses as a result from movement in share prices. This is a risk faced by all participants. As long only investors, there’s limited one can do to reduce market risk (other than exiting the market altogether). With market risk, the best option investors can take is to optimise its portfolio risk-reward profile.
Secondly, specific risk is risk that are diversifiable. In other words, this is the risk of being too expose to any one company, industry or country. The big question is what is the optimal number of stocks you should hold to eliminate large chunk of specific risk? To achieve this, we think 10-15 names will suffice. In fact, research by Evans & Archer (1968) suggested that as few as 10 randomly chosen stocks were needed to mimic the entire stock market from a risk perspective.
Lastly, systemic risk is the risk of a large-scale failure of a financial system. Generally occur from capital providers (banks), the 2008 financial crisis provided a roadmap of what could happen in a systemic-led meltdown. In many ways, one can categorised systemic risk as known unknowns, whereby we know its existence but unable to quantify its impact with reasonable confidence.
How do you measure risk?
In this section, we explore a few key metrics investors can use to effectively risk manage investments.
Sources of return: alpha and beta
To analyse the quality of return, we dissect the sources of return into alpha and beta. The estimation loosely follows the equation
Total return = Alpha + ( Beta x market return )
(Intuitively, alpha and beta refers to skills and luck, respectively. And yes, preferably more alpha than beta.)
Alpha represents the additional return gained over the general movement of the market. For this reason, alpha is also known as investors’ stock picking skills. Readers will have realised that alpha is indeed unobservable. We’ll revisit this with an example later.
On the other hand, beta of an investment measures how sensitive it is to a stock index. Think about it as a multiplier. Beta of a stock index is assumed to be 1. Consequently, if a stock has a beta of 1.5, this means that should the market gain +10%, one would expect the stock to be up +15%, in general. Similar applies for stock with beta <1.
Here’s an example, looking at our Disney idea, the assumptions are
- We bought the stock at $100
- Disney is currently trading at $115, with a beta 1.08
- Over the same time period, S&P 500 (index) gained 3.5%
Rearranging the equations gives
Alpha = ( $115/$100 ) – ( 1.08 x 3.5% ) = 11.2%
Positive alpha 🙂 Great, maybe I’m actually skilful after all. Anyways, back to the example, the 15% gained from Disney derives from 11.2% of alpha and 3.8% of beta.
In risk management, understanding how you generate your return is as important as what stocks to buy. Especially for DIY investors, this highlights your strength and weakness in your investment process.
Volatility & risk-adjusted return
A popular measure of “risk” is standard deviation of stock returns. Better known as volatility, it measures the variation of stock returns. Intuitively, higher variation means high volatility, leading to higher chances of making a loss (or gain).
Volatility is exceptionally useful when analysing a portfolio’s risk-adjusted return. Sharpe ratio, as is known, calculates the portfolio’s return per unit risk.
Sharpe ratio = ( Total return – risk-free rate ) / Volatility of portfolio
(For simplicity, we can assume risk-free rate = 0)
From the equation, it’s clear that having a Sharpe ratio of >1 means that you’re generating more return than the risk you’re taking. Maximising Sharpe ratio is obviously a good thing!
Here’s an interesting thought, if given only two choices, to maximise your Sharpe, will you aim to maximise “Total return” or minimise “Volatility”? Why?
Position sizing relates to the proportion of an investment in your portfolio. In addressing concentration risk, it’s worth considering whether this is intentional or not. If your goal is to own only a few stocks, then naturally your concentration risk will be high. It makes little sense for a portfolio of 20 stocks, with 95% of the portfolio invested in a single stock, for example. By definition, a highly concentrated portfolio often leads to higher volatility.
In addition, position sizing should reflect investors’ confidence and conviction. Allocating sufficient capital to high conviction ideas and stocks is a key aspect of financial risk management. You should be seeking concentration risk if you’re intending to!
We mentioned earlier that risk management includes the awareness of current investments. Owning a stock is much more than being exposed to that particular company. In addition, you are exposed to the country it operates, the industry it does business, fluctuation of currencies used to run the company and so on.
Critically, exposure analysis fleshes out any unintended risk-taking that may occur in your portfolio. For example, owning Apple for its formidable balance sheet and subsequently being downbeat about global demand for smartphones, may impede sound risk management. Being aware of your exposure to currencies, countries and industries is a good starting point.
Value at Risk
Value-at-Risk, or VaR, is one-number estimate that tells you how much you might lose in your portfolio over a defined time period. It gives you a relative indication of how resilient your portfolio is. For example, you can simulate a “before and after” portfolio scenario upon adding a new stock.
Truth to be told, this number rarely works in real-life. It’s something like an airbag that works all the time, except when you have an accident. Typically, VaR only works well in normal market conditions. It remains useful when using it in conjunction with other measures.
The concept of stop-loss means exiting a position when it hits a certain loss threshold. This is more applicable to day traders given the shorter time horizon. For most investors, a stop-loss on a portfolio level makes more sense than on a single stock basis.
In particular, DIY investors should use stop-loss as an indicator to revisit and rethink your portfolio. Actions to be taken are not limited to exiting positions, but may also include adding to stocks you have large conviction despite the setback in share prices.
Improving returns through risk management
Bringing all our discussions together, here are the key steps on how to improve your returns through better risk management.
Investment objectives and risk targeting
First is to set out investment objectives. These include targeted return, time horizon and risk targets. For example, a targeted return of 15% for the year with a 15% volatility. Initially, these numbers don’t have to be set in stone. As portfolio starts to evolve over time, you’ll have a better idea of what targets to aim for.
Armed with a spreadsheet, most of risk measures discussed above can be obtain on a real-time basis. Exposure, source or risk and return should be constantly validated against investment convictions.
A quick summary of the measures above:
- Alpha and beta: Investors should aim to maximise alpha.
- Volatility & risk-adjusted return: Aim to achieve a Sharp close to 1.0 or better.
- Position sizing: 10-15 positions is a good size.
- Exposure: No one size fits all. More important to be aware and align with investment beliefs.
- Value at Risk: Similar to exposure.
- Stop-loss: Should aim for a signal to reconsider your portfolio rather than a mechanical trigger of exiting positions.
Monitoring and feedback
Perhaps the most important step of the process is monitoring and providing feedback. Risk is always evolving and hence have to be monitored on a regular basis. Feedback is important to right-size your investment objectives.
Risk management is not exclusive to professional investors. With this article, we look to raise the awareness among everyday investors and markedly improve investment returns along the way. Risk management is a process, not a box-ticking exercise.
Today, risk continues to be regarded as something negative and frown upon. Risk and return tend to go hand in hand, eliminating risk blindly would mean reduced returns. Rather, the goal is to eliminate unnecessary, unwanted and excessive risk.
There's no one size fits all.
We’ll leave you a quote that we very much adhere to: “The biggest risk of all is investing in things you don’t understand.” No risk management can save you from that!