What Is Financial Risk Management?

Financial Risk Management Explained

An investor looks over his portfolio.
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In finance, risk management is a process of identifying, evaluating, and controlling the risk in a portfolio. Having a sound risk management strategy is essential for any investor, as even the safest investments carry some level of risk.

Learn the various types of risks you could face in investing and ways you can incorporate risk management principles into your investment decisions.

Definition and Examples of Risk Management

Risk management when investing is the process of identifying investment risk and determining the best way to address that risk. The goal of a risk management plan is to keep potential losses within a range that’s acceptable based on your risk tolerance.

In certain areas of your life, you may already practice risk management. For example, buying car insurance is a form of risk management because you’re reducing the financial impact if you get in an accident.

Insurance companies practice risk management by charging premiums based on the probability that they will have to pay one or more claims. They also insure large numbers of people, thereby making losses relatively predictable. Plus, each insured person usually retains a portion of the risk through co-pays, coinsurance, and deductibles, depending on the type of policy.

Risk isn’t necessarily a negative thing. Taking on greater risks typically comes with the possibility of greater returns.

How Risk Management Works

Investors can approach risk management in several different ways, but in most cases, the process is the same: analyze and strategize.

Two popular metrics for analyzing a stock or fund’s risk are its beta and alpha.

Beta Coefficient

A stock or fund’s beta coefficient is a good way to gauge risk quickly. Beta measures how volatile a stock is compared to the overall stock market, typically represented by the S&P 500 index. A stock with a beta of exactly 1.0 has the same level of volatility as the stock market. If its beta is less than 1.0, it’s less volatile. A beta above 1.0 indicates greater volatility compared to the market. For example, a stock with a beta of 1.1 is 10% more volatile than the stock market.

Volatility is how widely the price of a stock or fund can swing—which indicates a potential for greater returns and greater losses.

Alpha

While beta measures volatility, alpha measures risk-adjusted performance. A positive alpha indicates that an asset’s return has exceeded its risk, while a negative alpha suggests that the return did not exceed the risk. Alpha and beta can be used together to determine if a particular stock or fund has been a good investment.

For example, if a stock has a 1.5 beta and the S&P 500 rises by 20%, you’d expect a return of 30% (20% x 1.5). But if you only earned a 25% return, the stock’s alpha is -5%. In other words, you weren’t adequately rewarded for the additional risk.

Types of Risk Management

Understanding beta and alpha can help you gauge an asset’s historical risk, but you’ll need to apply a risk-management strategy that protects against potential losses. Some of the more popular strategies are portfolio diversification, buy-and-hold, and equity glide path.

Portfolio Diversification

Having a diversified portfolio is also essential for managing risk. Investing in a single company or industry is risky. For example, you could potentially pick a poorly-run company or one that gets hit with an antitrust suit, even in an industry that’s outperforming others. Investing across the overall stock market reduces the risk. One way to diversify instantly is to invest in mutual funds or exchange-traded funds (ETFs).

Buy-and-Hold

Adopting a buy-and-hold strategy can also reduce risk over time. A Fidelity study of 1.5 million workplace savers found that people who kept their money invested after the stock market dropped by nearly 50% in late 2008 and early 2009 grew their account balances by 147% between June 2008 and the end of 2017. Those who cashed out of stocks in the fourth quarter of 2008 or the first quarter of 2009 earned average returns of just 74% through 2017.

Equity Glide Path

An equity glide path is a common approach to risk management that focuses on age-based asset allocation. Younger investors can often afford more risk because their money has more time to recover from losses. Someone in their 20s and 30s might invest aggressively by putting most of their money in stocks. As the investor gets closer to retirement, they’d shift money out of stocks and into safer assets with lower returns, like bonds and CDs.

For example, suppose you start at age 25 with 90% invested in stocks and 10% invested in bonds. But by age 50, you may have 70% in stocks and 30% in bonds. By age 60, your portfolio might be 50% stocks and 50% bonds and CDs, especially if you’re hoping to retire soon.

Securities and Exchange Commission (SEC) regulations require mutual fund managers to disclose investing risks in the fund’s prospectus.

Types of Risk

There are many types of risks you face as an investor. The following are some of the most common types of investment risks, along with strategies that could help mitigate them.

Business Risk

If the company files for bankruptcy and you’re a stockholder or bondholder, you could be left with nothing after liquidation. The risk is higher for shareholders than it is for bondholders because bondholders get paid before shareholders in bankruptcy proceedings.

Diversification is the best strategy for reducing business risk. A good rule of thumb is to avoid having more than 5% of your portfolio invested in a single company.

Market Risk

Even when you invest in a diversified mix of financially sound companies, you face market risk, which is the risk of losing money because the stock market tanks. For example, the S&P 500 index temporarily dropped 34% between February 2020 and March 2020 due to the pandemic.

Market risk is less worrisome for younger investors who have time to allow their portfolios to recover. But a prolonged downturn is a big threat for investors approaching retirement. Proper asset allocation and periodic rebalancing are vital to reducing market risk. Investing in stocks with a beta of less than 1.0 could also lower market risk.

Inflation Risk

Inflation risk is the risk that your returns won’t keep up with inflation. Your money will lose purchasing power as a result. This is a major concern for people who invest in low-risk assets, like bonds and CDs. The only way to reduce inflation risk is by investing in higher-risk asset classes such as stocks.

Investing in dividend-paying stocks with a track record of regular increases can provide a safeguard against inflation.

What It Means for Individual Investors

There’s no way to avoid all risk, but a good risk management plan may help mitigate the potential damage.

Individual investors should think long-term when building a risk management strategy.

Young individuals might manage risk by starting with an aggressive allocation and gradually shifting to more conservative investments over time. Diversification is also key to risk management. Your risk management strategy will change based on your age and goals, so it’s essential to periodically revisit the level of risk in your portfolio and whether it’s appropriate for you.

Key Takeaways

  • All investments carry some level of risk, but a risk management plan will help you identify and mitigate those risks.
  • An aggressive asset allocation is often recommended for young investors.
  • As investors near retirement, a gradual shift to more conservative allocations is advised.
  • Diversification is an essential part of a risk management plan and can be accomplished by investing in mutual funds and ETFs.