Risk is the universal truth in the investment and business world, birth of risk takes place in the arena of uncertainty which is stored in the future .In other way risk is the integral part of the growth so, if one has to grow they have to take calculated risk and here comes risk management.
Risk associated with Investment
Organizations can't plan for their finance without understanding investment risk. Many people when they hear about 'risk' think automatically about the chance of being defrauded or not getting all their money back. This 'capital' risk is important but isn't the only type.
Other types of risk involve uncertainty and unpredictability. When you make an investment, it can be difficult to say with any certainty what you'll get back when you finally cash it in.
Share prices fluctuate, interest rates vary, and inflation is a risk too. Just concentrating on capital risk and ignoring these other risks can mean you take too cautious an approach.
Understanding risk means identifying your own attitude to risk and identifying the different types of risk. Then you can pick up tips for minimizing the chances of things going wrong.
Different types of risk:
Capital risk
Theoretically speaking, every investment carries at least some risk that you won't get back all the capital you invested. This is known as capital risk. However in practice several products are so safe that it's virtually certain you'll get what you were promised. For example, National Savings Certificates, Post office deposits and government bonds (gilts) are backed by the government.
But other asset class like equity corporate deposits other debt investments, Real states investments holds significant capital risk.
Inflation risk
Inflation risk is the danger of rising prices eroding the buying power of your money. This risk is greatest if you invest in savings accounts and bank fixed deposits.
Sometime many savings accounts don't pay interest equal to the rate of inflation after tax, so even if one doesn't spend any of the interest, the 'real' value of your savings falls. If you spend the interest, the problem is even greater.
Shortfall risk
Shortfall risk means failing to reach your investment goal because the return on your investments is too low. For example, say you want to save Rs20,000 and can get a return of 3.4% after tax from a savings account. This means you'd have to save Rs140 a month to reach your target. If you can only save Rs100 a month, you'd need a return of 6.9%.
To reduce shortfall risk, you need to invest at least some of your money for a higher return but this may involve taking some capital risk.
Share-based risk
Specific risk
This is the risk that the company one have invested in performs badly. Some companies will fluctuate more than others. First time investors should be especially concerned to keep this type of risk to a minimum.
This could be done by building up less risky assets first - so if you buy share-based investments they'll have less effect on your overall portfolio. You can also reduce your specific risk by investing across a range of shares. This way, if one of them goes bust, or falls heavily, the overall effect on your portfolio is less.
The best and cheapest way to spread your risk is to invest in pooled investments like Mutual fund, investment trusts. They are called pooled investments because you pool your money with other savers to buy a wide range of shares.
Market risk
This is the risk of a fall in the particular country's stock market where your money is invested. When a market falls you will usually find that most shares are dragged down with it. Some fall by more than the average, some by less, but few will buck the overall trend.
A good way of avoiding market risk is to invest your money gradually, for example through a monthly investment scheme as this will smooth out big variations in the price.
You can reduce market risk by investing in many stock markets around the world. This works because not all stock markets will rise and fall together by the same amount, so if one crashes, you should be able to limit your losses because the others won't have fallen as much.
Currency risk
If your money is invested in stock markets outside the country, then one will face currency risk. Wherever money is invested, it will have to be converted into currency of host nation, when one want it back. As a result, movements in the exchange rate will affect the value of your investment - this can work in your favor or against the investor. When FII were pumping the money in Indian market that time rupee were quoting at 39 but when they were selling from the country the rupee close to 52 look the risk involve with the currency.
one can limit currency risk by diversifying, for example through an international fund that spreads its investments around the globe. Alternatively, one can avoid currency risk by sticking to the one nation but this increases your market risk.
Fund Manager risk
There is a huge variation in the investment performance of individual fund managers of unit and investment trusts. It would be great if we could pick the winners in advance, but over the long-term bet very few managers manage to beat the stock market.
Investing through an index-tracking fund should remove the risk of picking a bad manager. Index trackers just try to follow their chosen index, such as the NIFTY All Share or the BSE 100. Index , MIDCAP Index trackers tend to have lower charges than funds where managers try to beat the market
Measuring and Managing Investment Risk:
We tend to think of "risk" in principally negative terms, as something to be avoided or a threat that we hope won't materialize. In the investment world, however, risk is inseparable from recital and, rather than being desirable or undesirable, is simply necessary. Understanding risk is one of the most important parts of a financial learning.
Risk - fine, dire and essential:
A general explanation for investment risk is deviation from an expected outcome. We can express this in absolute terms or relative to something else like a market benchmark. That deviation can be positive or negative, and relates to the idea of "no pain, no gain" - to achieve higher returns in the long run you have to accept more short-term volatility. How much volatility depends on risk tolerance of the individual - an expression of the capacity to assume volatility based on specific financial circumstance and the inclination to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short-term losses.
Absolute Measures of Risk:
One of the most commonly used absolute risk metrics is standard deviation, a statistical measure of dispersion around a central tendency. I am taking the example of most stable and mature equity index of the globe for the explanation , during a 15-year period from August 1, 1992, to July 31, 2007, the average annualized total return of the S&P 500 Stock Index was 10.7%. This number tells you what happened for the whole period, but it doesn't say what happened along the way.
The average standard deviation of the S&P 500 for that same period was 13.5%. Statistical theory tells us that in normal distributions (the familiar bell-shaped curve) 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 S&P 500 investor could expect the return at any given point during this time to be 10.7% +/- 13.5% just under 70% of the time and +/- 27.0% 95% of the time. The Indian market has shown same trend since July 1990 till latest quotes in 2009.
Risk and Psychology
While that outcome may be helpful, it does not fully address an investor's risk concerns. The field of behavioral finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory, an area of behavioral finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion - they put more weight on the pain associated with a loss than the good feeling associated with a gain.
Thus, what investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things look way down on the left-hand tail of the distribution curve. Value at risk (VAR)attempts to provide an answer to this question. The idea behind VAR is to quantify how bad a loss on an investment could be with a given level of confidence over a defined period of time. For example, the following statement would be an example of VAR: "With about a 95% level of confidence, the most you stand to lose on this $1,000 investment over a two-year time horizon is $200." The confidence level is a probability statement based on the statistical characteristics of the investment and the shape of its distribution curve.
Of course, even a measure like VAR doesn't guarantee that things won't be worse. Spectacular debacles like hedge fund Long Term Capital Management in 1998 remind us that so-called "outlier events" may occur. After all, 95% confidence allows that 5% of the time results may be much worse than what VAR calculates. In the case of LTCM, the outlier event was the Russian government's default on its outstanding sovereign debt obligations, an event that caused the hedge fund's performance to be much worse than its expected value at risk.
Another risk measure tilting to behavioral tendencies is drawdown, which refers to any period during which an asset's return is negative relative to a previous high mark. In measuring drawdown, we attempt to address three things: the magnitude of each negative period (how bad), the duration of each (how long) and the frequency (how many times).
Risk: The Passive and the Active
In addition to wanting to know, for example, whether a mutual fund beat the NIFTY and other indexes we also want to know how comparatively risky it was. One measure for this is beta, based on the statistical property of covariance and also called "market risk", "systematic risk", or "non-diversifiable risk". A beta greater than 1 indicates more risk than the market and vice versa.
Beta helps us to understand the concepts of passive and active risk. The graph below shows a time series of returns (each data point labeled "+") for a particular portfolio R(p) versus the market return R(m). The returns are cash-adjusted, so the point at which the x and y axes intersect is the cash-equivalent return. Drawing a line of best fit through the data points allows us to quantify the passive, or beta, risk and the active risk, which we refer to as alpha.
The gradient of the line is its beta. For example, a gradient of 1.0 indicates that for every unit increase of market return, the portfolio return also increases by one unit. A manager employing a passive management strategy can attempt to increase the portfolio return by taking on more market risk (i.e. a beta greater than 1) or alternatively decrease portfolio risk (and return) by reducing the portfolio beta below
1. Influence of Other Factors
If the level of market or systematic risk were the only influencing factor, then a portfolio's return would always be equal to the beta-adjusted market return. Of course, this is not the case - returns vary as a result of a number of factors unrelated to market risk. Investment managers who follow an active strategy take on other risks to achieve excess returns over the market's performance. Active strategies include stock, sector or country selection, fundamental analysis and charting.
Fund managers are on the hunt for alpha - the measure of excess return. In our diagram example above, alpha is the amount of portfolio return not explained by beta, represented as the distance between the intersection of the x and y axes and the y axis intercept, which can be positive or negative. In their quest for excess returns, active managers expose investors to alpha risk - the risk that their bets will prove negative rather than positive. For example, a manager may think that the energy sector will outperform the S&P 500 and increase her portfolio's weighting in this sector. If unexpected economic developments cause energy stocks to sharply decline, the manager will likely underperform the benchmark - an example of alpha risk.
A note of caution is in order when analyzing the significance of alpha and beta. There must be some evidence of a linear pattern between the portfolio returns and those of the market, or a reasonably inclusive line of best fit. If the data points are randomly dispersed, then the line of best fit will have little predictive ability and the results for alpha and beta will be statistically insignificant. A general rule is that an r-squared of 0.70 or higher (1.0 being perfect correlation) between the portfolio and the market reasonably validates the significance of alpha, beta and other relative measures.
The Price of Risk
There is economic cost to the decision between passive and active risk. In general, the more active the investment strategy (the more alpha a fund manager seeks to generate) the more an investor will need to pay for exposure to that strategy. It helps to think in terms of a spectrum from a purely passive approach. For example, a buy and hold investment into a proxy for the C&X NIFTY or NIFTYJr - all the way to a highly active approach such as a hedge fund employing complex trading strategies involving high capital commitments and transaction costs. For a purely passive vehicle like an index fund or an exchange trade fund ETF) you might pay 15-20basis points in annual management fees, while for a high-octane hedge fund you would need to shell out 200 basis points in annual fees plus give 20% of the profits back to the manager. In between these two confines lie alternative approaches combining active and passive risk management.
The discrepancy in pricing between passive and active strategies (or beta risk and alpha risk respectively) encourages many investors to try and separate these risks: i.e. to pay lower fees for the beta risk assumed and concentrates their more expensive exposures to specifically defined alpha opportunities. This is popularly known as portable alpha, the idea that the alpha component of a total return is separate from the beta component.
For example a fund manager may claim to have an active sector rotation strategy for beating the S&P 500 and show as evidence a track record of beating the index by 1.5% on an average annualized basis. To the investor, that 1.5% of excess return is the manager's value - the alpha - and the investor is willing to pay higher fees to obtain it. The rest of the total return, what the S&P 500 itself earned, arguably has nothing to do with the manager's unique ability, so why pay the same fee? Portable alpha strategies use derivatives and other tools to refine the means by which they obtain and pay for the alpha and beta components of their exposure.
Conclusions
Risk is integral part of return. Every investment involves some amount of risk, which can be very close to zero in the case of a Government security or very high for something such as concentrated exposure to African equities or real estate in Argentina the spatiotemporal variation plays important role in risk. Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs and costs involved with different investment approaches.
