Risk is not just a four-letter word

In the managed futures course I teach at DePaul University in Chicago, the first question I ask the students is “what is risk?” The usual response is that it relates to losing money in the markets. Yes, this is true. However, I like to say risk is like ice cream because it’s available in many flavors. This may include legal risk, headline risk/ reputational risk, political risk, commodity risk, key-person risk, weather risk, cybersecurity risk, investment risk, liquidity risk, regulatory risk, disaster recovery, asset liability management and the list goes on.

Ultimately, risk is about a negative impact and trying to mitigate it as much as possible. Webster’s dictionary defines risk as a “possibility of loss or injury” or “someone or something that creates or suggests a hazard”. Risk management focuses on the probabilities of negative results during moments of uncertainty. 

Life and the capital markets are a constant stream of uncertain moments. To quote from a risk management article I wrote several years ago: “Depending on how one frames a negative outcome, it does not necessarily mean a losing period. It also refers to underperforming expectations or a benchmark”, hence, benchmark risk.

Also “The more one understands the normal tendencies of the investment, the greater the ability to create a profile and maintain proper expectations of the investment’s performance.”*

This profiling would include understanding the drawdown and recovery characteristics of an investment and that drawdowns are an expected scenario in the longer duration of an investment. When drawdowns occur and they will happen from time to time, as with most investments, it won’t be a surprise. 

Risk management is a combination of quantitative and qualitative attributes.

For example, due diligence of a fund manager is a risk management process where you analyse both the portfolio and back office operations. Analysing diversification and how rolling correlations may offer greater insight in various market environments versus static correlations. This relates to utilising portfolio diversification as a method of risk management in an effort to control for the downside risk of your portfolio.

Mark Shore is Director of Educational Research, Coquest Advisors and Adjunct Professor, DePaul University. 

References:

*Shore, M. (2008) Introduction of Risk Management.

Disclaimer: Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.