The Intersection Of Auto Insurance And Personal Finance In New York – Risk management involves identifying, analyzing and accepting or mitigating uncertainty in investment decisions. Simply put, it is the process of monitoring and managing the financial risks associated with investing. Risk management essentially occurs when an investor or fund manager analyzes and attempts to measure the potential for losses in an investment, such as moral hazard, and then takes appropriate action (or inaction) to meet their objectives and risk tolerance. .
Risk is inseparable from return. Every investment involves a certain degree of risk. It can be close to zero for US Treasuries or very high for emerging market stocks or real estate in high inflation markets. Risk is quantified in absolute and relative terms. A solid understanding of risk in its various forms can help investors better understand the opportunities, trade-offs and costs associated with different investment approaches.
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Risk management involves identifying and analyzing where risk exists and making decisions about how to deal with it. It happens everywhere in the field of finance. For example:
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Careful risk management can help reduce the chances of losses while ensuring that financial goals are met. However, inadequate risk management can result in severe consequences for companies, individuals and the economy. The subprime mortgage meltdown that led to the Great Recession resulted from poor risk management. Lenders gave mortgages to people with bad credit and investment firms bought, packaged and resold these loans to investors as risky mortgage-backed securities (MBS).
The word risk is often considered negative. But risk is an integral part of the investment world and is inseparable from performance.
Investment risk is a deviation from the expected outcome. This deviation is expressed in absolute terms or relative to something else such as a market benchmark. Investment professionals generally accept the idea that deviation implies some degree of intended outcome for your investments, whether positive or negative.
To achieve higher returns, one is expected to accept higher risk. It is also widely accepted that increased risk means increased volatility. While investment professionals are constantly looking for and occasionally finding ways to reduce volatility, there is no clear agreement on how to do it.
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How much volatility an investor should accept depends entirely on their risk tolerance. For investment professionals, it is based on the tolerance of their investment goals. One of the most commonly used measures of absolute risk is the standard deviation, which is a statistical measure of dispersion around a central tendency.
Here’s how it works. Take the average return on an investment and find its average standard deviation over the same time period. Normal distributions (the famous bell-shaped curve) dictate that the expected return on an investment can be one standard deviation from the mean 67% of the time and two standard deviations from the mean 95% of the time. This provides a numerical risk assessment. If the risk is tolerable (financially and emotionally), they can invest.
Behavioral finance emphasizes the imbalance between people’s views of gains and losses. In prospect theory, an area of behavioral finance pioneered by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion
They observed that investors put roughly twice as much weight on the pain associated with a loss as on the good feeling associated with a profit.
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Investors often want to know the losses that come with an investment, as well as how much the asset deviates from the expected outcome. Value at Risk (VAR) attempts to measure the degree of loss associated with an investment with a given level of confidence over a specified period. For example, an investor can lose $200 on a $1,000 investment with a 95% confidence level over a two-year period. Note that a measure like VAR does not guarantee that 5% of the time it will be much worse.
Also, no external events have been taken into account, which have affected the Long Term Capital Management (LTCM) hedge fund. 1 trillion dollars. His failure could have brought down the global financial system. But the US government created a $3.65 billion loan fund to cover losses, allowing LTCM to survive the volatility and liquidation of early 2000.
A confidence level is a statement of probability based on the statistical characteristics of an investment and the shape of its distribution curve.
One behavioral risk measure is the pullback, which refers to any period in which an asset’s return is negative relative to a previous high. When measuring drag, we try to address three things:
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For example, in addition to wanting to know whether a mutual fund has beaten the S&P 500, we also want to know its comparative risk. One measure of this is beta. Also called market risk, beta is based on the statistical property of covariance. A beta greater than 1 indicates greater market risk, while a beta less than 1 indicates less volatility.
Beta helps us understand the concepts of passive and active risk. The graph below shows a time series of returns (each data point marked with a “+”) for a particular portfolio R(p) versus the market return R(m). Returns are cash-adjusted, so the point where the x- and y-axes intersect is the cash-equivalent yield. Drawing a line of best fit through the data points allows us to measure passive risk (beta) and active risk (alpha).
The line gradient is its beta version. So a gradient of 1 indicates that for every unit increase in the market return, the portfolio return also increases by one unit. A money manager using a passive management strategy may seek to increase portfolio return by taking on more market risk (ie, a beta greater than 1) or alternatively reduce portfolio risk (and return) by reducing the beta portfolio below one.
If market or systematic risk were the only influencing factor, then the portfolio return would always equal the beta-adjusted market return. But this is not so. Returns vary due to a number of factors unrelated to market risk. Investment managers following an active strategy take other risks to achieve returns in excess of market performance, including:
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Active managers hunt for alpha, a measure of excess return. In our chart example above, alpha is the amount of portfolio return not explained by beta, which is represented as the distance between the intercept of the x- and y-axes and the intercept of the y-axis. This can be positive or negative.
In their pursuit of excess returns, active managers expose investors to alpha risk, the risk that the outcome of their bets will turn out to be negative rather than positive. For example, a fund manager may think that the energy sector will outperform the S&P 500 and increase her portfolio’s weighting in this sector. If an unexpected economic development causes energy stocks to drop sharply, the manager will likely fill the benchmark.
The more alpha an active fund and its managers can generate, the higher the fees they tend to charge. For purely passive vehicles, such as index funds or exchange-traded funds (ETFs), you’ll likely pay between one and 10 basis points (bps) in annual management fees. Investors can pay 200 bps in annual fees for a high-octane hedge fund with complex trading strategies, high capital commitments and transaction costs. They may have to return 20% of the profits to the manager.
The price difference between passive (beta risk) and active strategies (alpha risk) encourages many investors to try to separate these risks, such as paying lower fees for beta risk taken and concentrating expensive exposures on specifically defined alpha opportunities. This is popularly known as carryover alpha, the idea that the alpha component of the total return is decoupled from the beta component.
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For example, a fund manager may claim to have an active sector rotation strategy to outperform the S&P 500 with a track record of outperforming the index by 1.5% on an average annual basis. This excess return is the manager’s value (alpha) and the investor is willing to pay higher fees to obtain it. The rest of the total return (what the S&P 500 itself earned) probably has nothing to do with the manager’s unique ability. Portable alpha strategies use derivatives and other tools to refine the way they receive and pay for the alpha and beta components of their exposure.
During the 15-year period from August 1, 1992 to July 31, 2007, the average annual total return of the S&P 500 was 10.7%. This figure reveals what happened for the entire period, but does not tell what happened along the way.
The average standard deviation of the S&P 500 for the same period was 13.5%. This is the difference between the average return and the actual return at most given points over the 15-year period.
When applying the bell curve model, any given outcome should be within one standard deviation of the mean about 67% of the time and within two standard deviations about 95% of the time. Thus, an S&P 500 investor can expect the return, at any point during this period, to be 10.7% plus or
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