Benefits of Risk Management in Stock Market
The benefits of risk management in the stock market make strategies to manage risk an essential part of successful investment management. Many investors have employed a simple buy and hold strategy that has destroyed wealth and has set back many retirement plans a decade or more. Remember, a 50% loss requires a 100% gain to breakeven. A 10% loss only requires an 11% gain to get back to breakeven.
Portfolio risk management requires:
1. Identification of potential risks.
2. Assessment of the magnitude and probability of those risks occurring.
3. Choosing a path or technique to optimize the risks and rewards of the portfolio.
The two major potential risk categories to identify are systematic risk and unsystematic risk. Systematic risk is risk associated with market returns. These are risks that are affected by macroeconomic factors that affect the market as a whole. These risks would include changes in interest rates, inflation, recessions, war, etc. Unsystematic risk is company specific or industry specific risk. This is risk specific to the individual investment or small group of investments and is uncorrelated with stock market returns.
After identifying risks the next step is to assess the potential damage and the probability of the risk occurring. Systematic risk, or market risk, can be estimated from historical data. We can measure the volatility and frequency of market declines and estimate the damage and probability of that damage fairly accurately over a long period of time. Unsystematic risk, or specific risk, requires a great deal of analysis for an individual investment because of the hundreds, or even thousands, of risk factors that could influence a company or industry.
Once identification and assessment are completed, there are 4 major risk management decision choices:
1. Avoid – eliminate or withdraw from investment choice.
2. Control – mitigate or optimize through action.
3. Transfer – outsource through hedging or insurance
4. Accept – make the investment knowing the risks
Avoiding and accepting risks are fairly straightforward decisions. The other two decisions, control and transfer, require further decision making. First priority should be to mitigate unsystematic or specific risk because it is the easiest and offers the largest benefits of risk management. If a portfolio consists of just a few stocks the entire portfolio can suffer severe damage if one stock experiences a large decline. However, a portfolio that consists of many stocks would suffer minimal damage from the decline of one stock. Diversification can nearly eliminate specific risk from a portfolio.
Systematic risk, or market risk, is not quite as easy to mitigate. Some investors may choose financial hedging; others may choose to partially avoid some market risk by increasing their asset allocation to fixed income or cash. As Portfolio Manager of the Arbor Asset Allocation Model Portfolio (AAAMP) I employ an active or tactical asset allocation strategy.
The biggest benefit of risk management in the stock market is portfolio optimization of risk and reward. A portfolio manager, willing to take a given amount of portfolio risk, can purchase individual higher reward/higher risk investments because risk management techniques lower overall portfolio risk. In other words, risk management allows a portfolio manager to place more aggressive assets in a portfolio without increasing risk exposure for the whole portfolio.
The Arbor Investment Planner offers investment management and asset allocation strategies for Self-Directed Investing. Feel free to use our Free Resources such as this blog and our Free Wealth Builder Newsletter. We also offer Premium Services for investors who want everything they need to manage their own money.
Portfolio risk management requires:
1. Identification of potential risks.
2. Assessment of the magnitude and probability of those risks occurring.
3. Choosing a path or technique to optimize the risks and rewards of the portfolio.
The two major potential risk categories to identify are systematic risk and unsystematic risk. Systematic risk is risk associated with market returns. These are risks that are affected by macroeconomic factors that affect the market as a whole. These risks would include changes in interest rates, inflation, recessions, war, etc. Unsystematic risk is company specific or industry specific risk. This is risk specific to the individual investment or small group of investments and is uncorrelated with stock market returns.
After identifying risks the next step is to assess the potential damage and the probability of the risk occurring. Systematic risk, or market risk, can be estimated from historical data. We can measure the volatility and frequency of market declines and estimate the damage and probability of that damage fairly accurately over a long period of time. Unsystematic risk, or specific risk, requires a great deal of analysis for an individual investment because of the hundreds, or even thousands, of risk factors that could influence a company or industry.
Once identification and assessment are completed, there are 4 major risk management decision choices:
1. Avoid – eliminate or withdraw from investment choice.
2. Control – mitigate or optimize through action.
3. Transfer – outsource through hedging or insurance
4. Accept – make the investment knowing the risks
Avoiding and accepting risks are fairly straightforward decisions. The other two decisions, control and transfer, require further decision making. First priority should be to mitigate unsystematic or specific risk because it is the easiest and offers the largest benefits of risk management. If a portfolio consists of just a few stocks the entire portfolio can suffer severe damage if one stock experiences a large decline. However, a portfolio that consists of many stocks would suffer minimal damage from the decline of one stock. Diversification can nearly eliminate specific risk from a portfolio.
Systematic risk, or market risk, is not quite as easy to mitigate. Some investors may choose financial hedging; others may choose to partially avoid some market risk by increasing their asset allocation to fixed income or cash. As Portfolio Manager of the Arbor Asset Allocation Model Portfolio (AAAMP) I employ an active or tactical asset allocation strategy.
The biggest benefit of risk management in the stock market is portfolio optimization of risk and reward. A portfolio manager, willing to take a given amount of portfolio risk, can purchase individual higher reward/higher risk investments because risk management techniques lower overall portfolio risk. In other words, risk management allows a portfolio manager to place more aggressive assets in a portfolio without increasing risk exposure for the whole portfolio.
The Arbor Investment Planner offers investment management and asset allocation strategies for Self-Directed Investing. Feel free to use our Free Resources such as this blog and our Free Wealth Builder Newsletter. We also offer Premium Services for investors who want everything they need to manage their own money.
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