Risk management occurs everywhere in the world of finance. It occurs when an investor buys US Treasury bonds over 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 such as options and futures, and money managers use strategies such as portfolio diversification, asset allocation, and position sizing to effectively mitigate or manage risk.
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Inadequate risk management can have dire consequences for companies, individuals and the economy. For example, the 2007 mortgage crash that helped trigger the Great Recession arose out of bad risk management decisions, such as lenders who provided mortgages to bad credit individuals. Investment companies that have purchased, packaged and resold these mortgages; And money that has been invested excessively in regrouped Mortgage Backed Securities (MBS), but remains risky.
How does risk management work
We tend to think of risk, mostly in a negative light. However, in the investment world, risk is essential and cannot be separated from desired performance.
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A common definition of investment risk is the deviation from the expected outcome. We can express this deviation in absolute terms or in relation to something else, such as a market standard.
While this deviation may be positive or negative, investment experts generally accept the idea that this deviation means a certain degree of the desired outcome for your investments. Thus to achieve higher returns one expects to accept more risks. It is also a generally accepted notion that increased risk comes in the form of increased volatility. While investment experts continually seek, and sometimes find, ways to reduce this volatility, there is no clear agreement between them on the best way to do so.
The amount of volatility an investor must accept depends entirely on the individual investor's risk tolerance, or in the case of the investment professional, to what extent his investment objectives permit. One of the most popular measures of absolute risk, standard deviation is a statistical measure of dispersion around a central trend. You look at the average ROI and then find the average standard deviation of it over the same time period. Normal distributions (the familiar bell-shaped curve) dictate that the expected return on investment is likely to be one standard deviation from the mean of 67% of the time and two standard deviations from the mean deviation 95% of the time. This helps investors evaluate risks numerically. If they think they can take risks, both financially and emotionally, they invest.
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Example
For example, during the 15-year period from August 1, 1992 to July 31, 2007, the average annual gross return of the S&P 500 was 10.7%. This figure reveals what happened throughout the period, but it does not explain 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 true return at most specified points throughout the 15-year period.
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When applying the bell curve model, any given outcome should fall within one standard deviation of the mean about 67% of the time and within two standard deviations about 95% of the time. Thus, an investor in the S&P 500 can expect that the return, at any given point during this period, will be 10.7% plus or minus the standard deviation of 13.5% around 67% of the time; It may also be assumed that 27% (two standard deviations) increase or decrease 95% of the time. If he can afford the loss, he is investing.
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