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Technical Analysis

Part 3: Risk Management of an Investment Portfolio

by Patrick Oberhaensli, on Jan 6, 2020 2:30:00 PM


In the first and second part of this series, we examined risk definitions within an investment and we presented the first part of the risk process with key aspects of its sub-components. In this article, we will continue our journey through the risk management process of an investment portfolio by discussing the risk measurement tasks. We will also begin to analyze the human biases and their effects on an investment. As a reminder, the risk management process is typically composed of the following 5 key steps.

Risk Management Process Framework for an investment portfolio

When examining the step “measure the risks” within the risk management process in the context of stressed markets, we find a (very) risky situation (well) beyond normal markets. The purpose of stress testing, in this case, is to take into account  abnormal market movements which have a strongly negative impact on the value of the investment portfolio.

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In the situation of stressed markets, the Expected Shortfall, also called the Conditional Value-at-Risk, can be used as a measure, as it is the average loss beyond (in the sense of worse) the VaR. Ideally, investors should look for a coherent risk measure, which fulfils a number of mathematical requirements that both make sense and are useful for the proper interpretation.

Treating the Risks

In the “treat the risks” stage, the investor makes a number of decisions in order to bring down the exposure closer to the "optimal" level. One decision is setting quantitative limits in relation to the market and credit risk taken. For instance, these limits can be decomposed into “normal markets limits” and “under stress markets limits” for risk control purposes. A risk-controlled context is the opposite of getting into an out-of-control situation. The more leverage is used, the higher the discipline needed in specifying (upfront) and applying the limits.

The Internal Control System or ICS allows investors to reduce the risks taken to an acceptable level. Of course, there can be parts of the system that are outsourced, but they still require oversight from the investor. Treating the risks is not only about ensuring, with reasonable efforts, that the market and credit limits are respected, but also about the performance evaluation: Has the desired performance been reached the way that was expected or has there been a style drift, meaning the portfolio manager is not doing  what was agreed. In the latter case, a rapid explanation from the portfolio manager is crucial.

It should be noted that not only is it basically impossible to guarantee proper execution, but it also would lead to excessive costs. Utilizing the Internal Control System (ICS) should be in line with the investors' available resources, keeping in mind that if not enough budget is allocated, failure will likely be unavoidable.

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The Human Factor and the Related Biases

The risk management organization and processes should take into account the human factor at both development and production levels whether it is for a small entity or a large institution. Humans don’t always behave rationally (a key dimension). A first step in dealing with the human biases properly is to understand what these biases are and their potential impact on the investment.

Human intelligence comes with emotions and when combined with a lack of knowledge and experience, a multitude of biases can appear. There are numerous biases associated with investment activities but unfortunately the concepts may (well) vary from one analyst/author to the other. Here, we will define the main human biases and the relationship with the risk management process. One needs to remember that these biases typically lead to operational risk (but are not limited to that risk) either in the development of projects or the activity production, in relation to managing assets.




From a risk perspective


Referring to an “old” basis that might not be adapted and the inability to change

Altered judgement in the context of discretionary management of the person managing the assets who likely misses the (necessary) forward-looking perspective. Or model risk (input and / or treatment of the data from a development point of view), as one ignores new information

Mental accounting

Dealing with “separate accounts” with each having its own objective

Typically, the diversification effect from an aggregated portfolio perspective is not given/ lost, partially or totally. Not understanding the risk at complete portfolio level can/will likely lead to lower returns


Considering only what confirms one’s own view (in order to re-confirm it)

Altered judgement in the context of discretionary management of the person managing the assets who likely has a subjective and/or insufficiently in-depth and forward-looking perspective. Or model risk (rather the input but can also be the treatment of the data from a development point of view), as one ignores other relevant information



The three mentioned human biases are among the most important ones: they all lead to a deteriorated or lacking perception of risks. As shown in the risk management process a link to the objectives taking account of the risks is the basis; this means that biases affect the process at its roots.

In the final part of this series of articles, we will discuss a number of additional human biases and introduce different ways to address them…


  • This content is not intended to be a solicitation nor an offer
  • The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible
Topic:Trading SignalsOnline Trading PlatformRobo-AdvisorActive TradingRisk ManagementInvestment Strategy
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About this blog is a personal finance blog. The articles posted provide relevant trading information, aspects, and opinions from expert professional traders and data and analytics providers.

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