Minimizing risk to maximize your financial future
Stanton Wade will work to help you minimize financial and other risks to your assets, business, or health. We consider everything from personal and professional liability, to business ownership, to property loss, to catastrophic illness or disability. A comprehensive look enables us to identify your sources of risk, recommend ways to avoid or minimize the major exposures, and, if necessary, recommend the appropriate insurance or other solution to allow you to feel confident about the future.
Asset protection planning manages risks to your wealth. Lawsuits, accidents, property damage, and other financial risks are facts of everyday life, and asset protection planning looks to transfer the risk of these events through insurance, repositioning asset ownership, and other protections available under the law.
What is Risk Management
In the financial world, risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given his investment objectives and risk tolerance.
Risk management occurs everywhere in the financial world. It occurs when an investor buys low-risk government bonds over riskier corporate bonds, when a fund manager hedges his currency exposure with currency derivatives, and when a bank performs a credit check on an individual before issuing a personal line of credit. Stockbrokers use financial instruments like options and futures, and money managers use strategies like portfolio and investment diversification to mitigate or effectively manage risk.
Inadequate risk management can result in severe consequences for companies, individuals, and for the economy. For example, the sub-prime mortgage meltdown in 2007 that helped trigger the Great Recession stemmed from poor risk-management decisions, such as lenders who extended mortgages to individuals with poor credit, investment firms who bought, packaged, and resold these mortgages, and funds that invested excessively in the repackaged, but still risky, mortgage backed securities (MBS)
How Do Investors Measure Risk?
Investors use a variety of tactics to ascertain risk. One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. You look at the average return of an investment and then find its average standard deviation over the same time period. Normal distributions (the familiar bell-shaped curve) dictate that the expected return of the investment is likely to be one standard deviation from the average 67% of the time and two standard deviations from the average deviation 95% of the time. This helps investors evaluate risk numerically. If they believe that they can tolerate the risk, financially and emotionally, they invest.
Risk and Psychology
While this information may be helpful, it does not fully address an investor’s risk concerns. The field of behavioural finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory, an area of behavioural finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion: they put more weight on the pain associated with a loss than the good feeling associated with a gain.
Risk: The Passive and the Active
Another risk measure oriented to behavioural tendencies is drawdown, which refers to any period during which an asset’s return is negative relative to a previous high mark. In measuring drawdown, we attempt to address three things: the magnitude of each negative period (how bad), the duration of each (how long), and the frequency (how often).
Influence of Other Factors
If the level of market or systematic risk were the only influencing factor, then a portfolio’s return would always be equal to the beta-adjusted market return. Of course, this is not the case as returns vary because of a number of factors unrelated to market risk. Investment managers who follow an active strategy take on other risks to achieve excess returns over the market’s performance. Active strategies include stock, sector or country selection, fundamental analysis, and charting.
The Bottom Line
Risk is inseparable from return. Every investment involves some degree of risk, which can be very close to zero in the case of a U.S Treasury security or very high for something such as concentrated exposure to Sri Lankan equities or real estate in Argentina. Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs, and costs involved with different investment approaches.