Last Updated on December 2, 2024
Overview – Risk Management and Investing
In a preceding article, we looked at what investment risk is, how risk varies from volatility, and a simple way to assess investment risk using the risk matrix.
Near the end of that article, we briefly touched on how no investment is 100% “risk-free”, and that there will always be the possibility of loss. A small, non-zero number is still non-zero. Not only that, but investment risk is not static – a low-risk investment operation today can easily become high-risk in the future.
Risk cannot be eliminated entirely: diminishing returns dictate that an infinite amount of money and resources would be needed to do so. Unsurprisingly, no person, company, or institution on earth has access to that.
This inability to remove risk entirely means we must learn to live with it and keep it on a tight leash: how can that be achieved? The practice of actively monitoring risks and to try and keep them from getting out of hand is called risk management, which if properly implemented, can make all the difference.
A Refresher on Risk
Recall that investment risk is defined as the probability of losing money and the amount of money an investor stands to lose. Investment risk could then be assessed using a risk matrix, such as the one shown below:
Now, just because an investment is deemed to have high risk doesn’t mean it needs to stay that way. There are several methods that can be employed to greatly reduce the risk of an operation as much as possible, with some methods being more effective than others:
Reducing risks as much as possible without the need to actively keep an eye on them is a key element of making something inherently safer, another topic we have also looked at.
When dealing with risks, the goal is always to reduce them to such a point that going any lower is not worth the time, effort, or money because of diminishing returns. If risk cannot be removed entirely, then the best we can do is to keep risk as low as reasonably practicable (ALARP). Below is a visual representation of this principle:
The Risk Management Process
When the correct steps are taken, many risks can be greatly reduced and brought down to such a level that they are more tolerable to live with, which we know is the residual risk. While risk can be brought down quite significantly, if left unattended risks that were previously classified as “low” can quickly prove to be a major headache once again.
Time, effort, and energy are needed to bring the level of risk down to an acceptable level, and those same resources are needed to ensure it stays low. This process of constantly reducing and monitoring risk is known as the risk management process, as shown below:
At a glance, this may seem a bit complicated, but in reality is a relatively straightforward process. Of course, the details of how this process is carried out will certainly vary based on what it’s being used on: risk management procedures on a chemical plant will look very different from the procedures used to keep an eye on forests that are prone to fires.
When carrying out this process, the key is to assess individual “nodes”; that is, smaller parts of the larger whole. For example, when trying to understand the overall risk of a chemical plant, this can be done by going through the risk management process on individual components such as reactors, pumps, and storage vessels. Once the risks of these individual nodes have been assessed, then the overall risk for the entire plant can be understood.
Regardless of where it’s being applied, the goal remains the same: reduce risks as much as possible, keep a close eye on them, and when they start to show signs of becoming a problem in the future, take steps to bring them down once again.
Applying Risk Management to Your Portfolio
Fortunately, the risk management process can be applied to an investment portfolio, but with a key distinction to keep in mind.
This distinction is that investment risk cannot always be handled in the same manner as other risks, at least when it comes to certain investment instruments like equities and bonds. When a chemical plant is at risk of blowing up because operating pressures are too high, steps can be taken to directly lower those pressures and keep them low. If a forest is at risk of experiencing a wildfire due to excess dry shrubs, then routine cleanups can be set up to make sure those shrubs don’t accumulate as much.
However, there are many factors that contribute to investment risk but are well beyond an investor’s control. Economic conditions, political developments, customer sentiment, managerial decisions: these are all variables that can potentially put an investor’s capital in jeopardy, yet they have very little, if any, control over them.
If investors can’t directly control many of the risks that affect them, then how can they still apply the principles of risk management? The answer lies in how they structure their portfolios, which is something they have full control over. Just as investors construct their portfolios in such a way to maximize returns, so too must they be constructed such that risk can be contained, presenting investors with a delicate balancing act.
Example: Going Through the Risk Management Loop (Equities)
To illustrate how exactly the risk management process can work in investing, let’s demonstrate by way of example, using Apple as the company we’ll be assessing:
(1) Do Planned Reviews – The first step in going through the risk management process is to set aside enough time to properly do so. Whether it’s every quarter, every six months, or even yearly, knowing when to perform this work will vary between different investors.
(2) Identify Hazards – Apple primarily sells consumer electronics such as iPhones, Apple Watches, and Macbooks, to name a few products. Apple’s success can arguably be pinpointed to three major factors: operating in numerous markets that have people with enough disposable income willing to buy their products, having the manufacturing capacity needed to keep up with demand, and their strong brand loyalty.
While these three factors can be seen as Apple’s pillars of success, they also represent potential hazards should any of them be compromised.
(3) Analyze for Risks – Going back to our aforementioned three pillars, they present the following potential risks:
- With respect to the markets they operate in, it’s possible for Apple to find themselves operating in a saturated market (i.e., everyone who wants to buy Apple products is already doing so), or fail to find new markets to expand to that meet their desired customer criteria.
- Apple’s products rely on timely manufacturing and having a strong supply chain in order to get the materials they need, when they need it. However, should the manufacturing process or supply chain be compromised, Apple may find themselves unable to meet customer demand or be forced to increase prices to meet revenue targets. The global chip shortage that started in 2020 due to the pandemic had a direct, adverse impact on Apple and their manufacturing/supply chain.
- Strong brand loyalty is largely the reason why Apple can consistently report strong sales figures year after year, even if they operate in fiercely competitive markets. However, should this brand loyalty weaken, Apple’s sales may start to decline as a result, and could even find themselves struggling in markets they’ve operated in for quite some time.
(4) Evaluate Risks. Are the risks acceptable? – Here, we come across a crossroads. Where we go next depends on our answer.
If the risks are acceptable:
(5) Manage the Residual Risk – If we feel comfortable with the current risks that Apple faces, and judge that they won’t affect its investment merit, then the next best thing we can do is to keep an eye on how these risk factors evolve over time.
If the risks are unacceptable:
(6) Can the Risks be reduced? – Remember, we can’t directly control Apple’s risks, but we can control how it takes up our portfolio. Once again we run into a crossroads.
If risk cannot be reduced: Step (8) – “discontinuing operations” in an investing context means divesting entirely. In this case, fully divesting from Apple.
If risk can be reduced: Step (7) – to reduce the risk, our options could be to decrease the number of Apple shares we own or purchase more shares of other companies to counter any potential losses we may get from Apple (preferably companies we already own so that we don’t have to analyze new prospects from scratch). The goal is the same: reduce the influence Apple has on our portfolio in case it takes a turn for the worse.
Risk Management Doesn’t Need to Be Complicated to Be Effective
The risk management example we just went over applies solely to equities, and of course, this isn’t the only way to manage risks associated with them. Naturally, other investment instruments such as real estate, commodities, or even currencies require different risk management approaches.
Regardless of which investment instruments need to be monitored, it’s important to keep something in mind: an effective risk management system doesn’t need to be overly complex for it to do its job.
It’s very easy to conflate “complexity” and “effectiveness”, especially when dealing with large portfolios comprised of several asset classes. Indeed, these sorts of portfolios will certainly need more robust and multi-layered risk management processes as opposed to one that’s worth only a couple thousand dollars and is comprised solely of equities.
However, just because a risk management system is complex there is no guarantee it’ll work better than a simpler one. In fact, creating an overly complex risk management system may negatively impact its effectiveness because of all the different, intertwined elements that are involved.
Of course, each portfolio will require different risk management strategies, but just because a certain strategy appears to be simple doesn’t mean it won’t get the job done. Investors are free to make their risk management processes as complex or simple as they want, but ultimately all that matters is that it can effectively reduce risk and keep it low without much hassle or fanfare.
Wrapping Up
One of the major problems that constantly plague investors is risk, or more specifically, keeping it under control. Any competent investor will do the best they can to ensure the investments they pursue don’t carry too much risk, however even the “safest” investments have the potential to one day grow to be major problems if left unattended.
Because investment risk is dynamic, adequate systems must be set up to ensure risks are routinely evaluated and minimized, all in an effort to keep them as low as possible. This is where risk management comes in.
Although different portfolios will certainly require different strategies, risk management doesn’t have to be an overly complicated affair for it to be effective. What matters is that the risk management processes an investor chooses to implement can help reduce risks before they spiral out of control and keep them low for as long as possible.
