Mitigating risks in Non-banking financial institutions – Best practices and strategies

Risk management is the practice of recognizing, assessing, and either minimizing or accepting uncertainty in investment choices. It revolves around monitoring and addressing financial risks linked with investments.

This process takes place when investors or fund managers evaluate and try to measure potential investment losses, including factors like moral hazards. They then take appropriate steps or refrain from actions to align with their goals and risk tolerance.

Risk management is integral to investing as it recognizes that risk is an inherent aspect of returns. Investments carry varying degrees of risk, ranging from minimal in U.S. T-bills to substantial in emerging-market equities or inflationary real estate. Understanding these diverse forms of risk aids investors in comprehending the trade-offs, opportunities, and costs linked with different investment strategies.

This process involves identifying and assessing existing risks and making decisions on how to handle them, spanning the entire financial domain. For example:

? Investors might opt for U.S. Treasury bonds over corporate bonds.

? Fund managers could use currency derivatives to hedge against currency exposure.

? Banks may evaluate an individual's creditworthiness before extending a personal line of credit.

? Stockbrokers utilize financial tools like options and futures.

? Money managers implement strategies like diversification, asset allocation, and position sizing for effective risk management.

By diligently managing risk, potential losses can be minimized while achieving financial objectives. On the contrary, inadequate risk management can lead to dire consequences for individuals, businesses, and the economy. An illustrative instance is the subprime mortgage crisis that triggered the Great Recession. Poor risk management led to lenders granting mortgages to individuals with weak credit, and investment firms packaging and reselling these risky loans as mortgage-backed securities to investors.

Risk management techniques encompass several strategies aimed at handling and mitigating risks associated with investments:

1. Avoidance: This technique involves steering clear of risks entirely. Some investors opt for this approach by choosing assets with minimal or no risks, prioritizing safety and stability.

2. Retention: With this strategy, individuals accept the risks that come with their investments. They acknowledge that risk is an inherent part of investing and are prepared to deal with potential losses.

3. Sharing: In this method, multiple parties agree to take on a predetermined share of the risk. For instance, reinsurers collaborate with insurance companies to collectively manage risks that might be too substantial for either party to handle independently.

4. Transferring: Risks are transferred from one party to another. A common example is health insurance, where individuals transfer the risk of medical costs to an insurer in exchange for regular premium payments.

5. Loss Prevention and Reduction: Instead of eliminating risks, this strategy focuses on minimizing losses and preventing them from spreading to other areas. Diversification, for instance, allows investors to reduce the impact of losses by spreading investments across various assets.

These risk management techniques provide investors and businesses with a range of options to approach risk. The choice of technique depends on individual risk tolerance, financial goals, and market conditions. By employing these strategies effectively, investors can make informed decisions that align with their risk appetite and overall investment objectives.

Investment risk involves the deviation from expected outcomes and is measured in absolute terms or relative to benchmarks. Professionals acknowledge that such deviation indicates a level of alignment or disparity between anticipated investment results and actual outcomes.

The relationship between risk and returns is well-established: to attain higher returns, a willingness to embrace greater risk is required. This inherently links risk with volatility, which is not definitively manageable despite continuous efforts by investment experts.

An investor's acceptable volatility level hinges on risk tolerance, while professionals' decisions are grounded in investment objectives. Standard deviation is a widely used metric to gauge absolute risk, quantifying the spread of returns around an average.

In practice, the standard deviation is applied by calculating the average return of an investment and determining its standard deviation over the same period. With normal distributions, it's projected that an investment's expected return can deviate one standard deviation from the average 67% of the time and two standard deviations 95% of the time, providing a numerical risk assessment. If the risk aligns with one's capacity and comfort, investment decisions can be made.

In risk management, different approaches and measurements are used to address various aspects of risk:

1. Drawdown and Behavioral Tendencies: Drawdown is a risk measure that considers periods when an asset's returns are negative compared to a prior high point. Drawdown analysis examines the severity, duration, and frequency of these negative periods.

2. Beta for Market Risk: Beta, a measure of market risk, takes into account the covariance between an asset's returns and those of the market. A beta greater than 1 signifies higher risk than the market, while a beta below 1 indicates lower volatility.

3. Passive and Active Risk: Beta helps distinguish between passive and active risk. The comparison of portfolio returns (R(p)) to market returns (R(m)) through a line of best fit reveals passive risk (beta) and active risk (alpha).

4. Confidence Level: The confidence level is a probability assessment based on the statistical attributes and distribution curve of an investment. It provides insight into the likelihood of various outcomes.

By using these risk management techniques, investors gain a better understanding of the potential risks associated with their investments. This enables them to make informed decisions based on their risk tolerance, investment objectives, and expectations for market behaviour.

Behavioural finance sheds light on the psychological aspects of risk management. It underscores the disparity between how individuals perceive gains and losses. In prospect theory, introduced by Amos Tversky and Daniel Kahneman in 1979, loss aversion is evident, as investors assign more significance to the pain of losses than the pleasure of gains.

Investors seek insight into potential losses and the extent of deviations from anticipated outcomes in investments. Value at risk (VAR) quantifies the potential loss associated with investment within a specified confidence level over a defined timeframe. For instance, an investor might expect a $200 loss on a $1,000 investment with a 95% confidence level over two years. It's important to note that VAR doesn't guarantee that only 5% of outcomes will be worse.

VAR doesn't factor in outlier events, exemplified by the 1998 crisis of Long-Term Capital Management (LTCM). Facing bankruptcy due to the Russian government's default, LTCM's highly leveraged positions of over $1 trillion threatened global financial collapse. However, a $3.65-billion loan fund established by the U.S. government enabled LTCM's survival, allowing it to weather volatility and liquidate by early 2000. This event highlights that extreme events can challenge conventional risk measures.

Behavioural finance's insights into loss aversion and the limitations of risk assessment tools like VAR remind us that emotions and unforeseen circumstances can significantly impact risk management, necessitating a holistic approach that integrates both psychological and statistical elements.

Active investment strategies involve taking on additional risks beyond market or systematic risk in order to generate returns that surpass the market's performance. While beta-adjusted market returns account for systematic risk, returns vary due to various factors unrelated to market risk.

Active investment managers employ tactics like leveraging stocks, sector or country selection, fundamental analysis, position sizing, and technical analysis to achieve excess returns over market performance. Their aim is to secure alpha, which represents the excess return generated beyond what can be attributed to beta. This can be positive (outperforming the market) or negative (underperforming the market).

In the quest for excess returns, active managers expose investors to alpha risk, which pertains to the possibility that their investment decisions might lead to negative outcomes rather than positive ones. For instance, if a fund manager increases the portfolio's weighting in the energy sector expecting it to outperform the market, unexpected economic events causing a sharp decline in energy stocks could result in underperformance relative to the benchmark.

Active management is not only about generating higher returns but also involves managing the inherent risks associated with deviating from the market's performance. Balancing the pursuit of alpha with prudent risk management is crucial for achieving successful outcomes in active investment strategies.

The cost of risk management varies based on the type of investment strategy pursued. Active funds that achieve alpha often charge higher fees. Passive options like index funds or ETFs usually have lower annual management fees, ranging from one to 10 basis points (bps). In contrast, complex hedge funds employing high-octane trading strategies and incurring transaction costs might charge 200 bps in annual fees, coupled with a profit-sharing arrangement where 20% of profits go to the manager.

The pricing disparity between passive (beta risk) and active strategies (alpha risk) prompts investors to segregate these risks. Portable alpha is a strategy where investors pay lower fees for beta risk exposure while concentrating higher-cost exposures on specific alpha opportunities. This approach separates the alpha component (excess returns) from the beta component (market returns).

For instance, a fund manager might offer an active sector rotation strategy claiming to beat the S&P 500 consistently by 1.5% on an average annualized basis. Investors are willing to pay higher fees for this added value (alpha). The remaining total return (market performance) is distinct from the manager's unique skill. Portable alpha strategies use derivatives and tools to refine how they acquire and pay for the alpha and beta components of their investment exposure. This allows investors to access alpha while minimizing costs associated with beta risk.

Over a 15-year period from August 1992 to July 2007, the S&P 500 exhibited an average annualized total return of 10.7%. However, this overall figure doesn't provide insight into the fluctuations that occurred along the way.

Throughout the same period, the S&P 500's average standard deviation was 13.5%. This metric signifies the typical variance between the average return and the actual return at various points within the 15-year timeframe.

Applying the bell curve model, it's anticipated that roughly 67% of outcomes would fall within one standard deviation of the mean, and about 95% within two standard deviations. This implies that an investor in the S&P 500 during this period could expect returns to deviate around 10.7% by about 13.5% about 67% of the time. Additionally, they could assume a more substantial 27% deviation (two standard deviations) up or down around the average return for approximately 95% of the time. Making an informed decision based on their risk tolerance, investors who can bear potential losses may proceed with their investment.

Risk management holds significant importance in the realm of investments and finance. It entails the identification, analysis, and decision-making related to uncertainties that can impact the achievement of goals. By implementing effective risk management strategies, investors and fund managers can navigate uncertainties while working towards their objectives, minimizing or addressing potential losses in the process.

To implement risk management in personal finance, follow these steps:

1. Identify Goals: Begin by defining your financial objectives.

2. Highlight Risks: Identify the potential risks linked to your goals.

3. Evaluate Risks: Assess the magnitude and likelihood of each risk.

4. Research Solutions: Research strategies to manage the identified risks effectively.

5. Monitor and Adjust: Continuously monitor your progress and make adjustments as needed to align with your goals.

By following these steps, individuals can proactively manage risks in their personal finances, ensuring that their financial objectives are achieved while minimizing potential setbacks.

Companies manage operational risk by following these steps:

1. Identify and Assess Risks: Recognize potential risks related to daily operations.

2. Measure Risks: Quantify the extent of identified risks.

3. Implement Controls: Establish measures to reduce, mitigate, or remove risks.

4. Monitor Operations: Continuously oversee business processes to identify potential risks.

5. Evaluate Effectiveness: Assess the success of risk management strategies.

6. Adapt and Improve: Modify approaches as needed to enhance risk mitigation.

By systematically applying these practices, companies can proactively address operational risks, safeguarding their day-to-day operations and ensuring smoother business continuity.

Risk is a significant aspect of finance, often associated with potential losses. However, it's essential to recognize that risk can lead to substantial rewards, especially in higher-risk investments. Understanding, identifying, and applying effective risk management techniques are vital for minimizing losses and maximizing gains. While risk can evoke negativity, it's a fundamental element that, when managed wisely, can lead to favourable outcomes in the financial realm.