Part 2: Risk Management of an Investment Portfolio
by Patrick Oberhaensli, on Dec 23, 2019 2:43:00 PM
The Risk Management Process
In the first part of our Risk Management article series, we defined the various areas of risk within an investment. In this 2nd part, we will use these definitions to describe the next main element of the framework: the risk management process. The risk management process is typically composed of the following 5 key steps.
The process and its sub-components will of course vary, especially depending on the investment approach used – as there are several different approaches, from simple to quite multifaceted. What is critical, is that the process needs to be adapted based on the size and complexity of the investment portfolio (these are the two key driving factors). And the mentioned “rough” steps of that iterative process remain essentially the same – even if the vocabulary might change.
The complete investment risk framework needs to be validated, particularly when referring to the models used for risk measurement (as model risk is also a factor). For a large(r) investor, this typically means that the board of directors also needs to give its approval.
Set The Objectives
Now, going back to the risk management process and its components. When talking about the objectives, the two related dimensions of risk and return need to be analyzed first with the risk being decomposed in its two elements: risk ability and risk willingness. Risk willingness is directly related to the investor’s behavior and therefore potentially (if not often) quite subjective.
In this context, the market risk the investor is willing and has the financial capacity to take is established – at least in an aggregated manner. This concept can further be illustrated by the following case in which the investor failed to take the necessary market risk by investing in the under-allocated risky asset as it lost (substantial) value. The failure was not because of an asset allocation that was not adapted, but rather it was due to a lack of discipline (insufficiently or disregarding rebalancing).
A common reaction in such a situation of panic is selling the risky asset (at likely the worst point in time). This question was critical in March 2009: if the diversified investor would have sold all his/her equities (at the worst point in time), the possibility to reach the objective in the future would have been likely strongly diminished.
In a classic constant-mix approach, which is common among institutional investors, equities would have even been bought during the 2009 stock market fall and certainly not sold. A rigorous risk management is therefore essential and allows investors to be prepared against the future problematic situations.
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How to Identify The Risks
“Identifying the risks” properly is a critical task. As mentioned in the first part of this series of articles, it is the original risk that matters most and needs to be identified. Although a particular risk, when it occurs, can of course have a multitude of impacts, they are technically not risks as such. To illustrate this, imagine a case where fraud exists within an investment portfolio. For example, entering knowingly into unauthorized big positions would be an operational risk where an important adverse price movement could further increase the losses. Therefore, it could potentially have a negative reputational impact in addition to the financial one. But at the end of the day, it derives from fraud… not market risk and not reputational risk.
In examining the “measuring risks” stage, we use the example of market risk. Ideally, a single and rather simple to interpret measure should be used for normal market conditions and stressed markets. This should be applied over the whole investment portfolio (we will discuss the “mental accounting “-bias in the next part).
Value-at-Risk or VaR is certainly among the best-known market risk measures. Beyond the classic volatility (the standard deviation of the returns) and the Tracking Error (TE) which refers to a benchmark, VaR is one figure representing the maximum loss for a particular time horizon and a chosen probability that is valid under normal market conditions.
An essential assumption is that the investment portfolio won’t be changed during that particular period (up to the VaR time horizon). However, for very active investment strategies that doesn’t necessarily make sense. Contrary to credit risk or even operational risk, market risk does not imply an expected loss. Instead, the investor takes risk in order to generate on average a positive return.
Now, depending on the nature of the portfolio, the so-called adapted risk mapping is done in order to express the exposure to individual securities in more general terms of their key factors. For equities, that means using the beta versus a common index, especially one where an easy-to-implement hedging is available typically, with (very) liquid futures.
However, for a fixed-income portfolio, it would be the duration and the credit rating classifications that would matter in that same context.
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In conclusion, investors look for a certain level of diversification in the portfolio. This implies, for example with an equity portfolio, a minimum spread among individual stocks in order to avoid concentration (risk). Dealing with each possible risk explicitly within a dedicated process helps to make the investment approach more consistent.
In the next part of this series, we will further the discussion of the risk management process starting with the continuation of the “measure the risks” in the stressed markets context and an introduction of the human biases exposé.
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