Risk Management is sometimes an intimidating topic that can easily become confusing and tedious. Let me try to make it easy to understand and maybe even fun too!
Let’s start with a story….
It’s late at night. You hear your trash can fall over behind the garage. You want to peak out of the kitchen window. What will you see? A burglar? What do I do? Where’s my cell phone? Are the doors locked? Why didn’t the motion detector on the floodlight go on?
So you peak out of the window and you see Jack, the neighbor’s tabby cat looking for scraps! You forgot to put the lid on the can. You breathe a sigh of relief! A cat made my adrenaline flow! Now that I know the risk I am dealing with (cat vs burglar), I now can decide what to do next. So you go outside and the light does turn on and you secure the garbage can with the lid.
So risk management is something that we are doing all the time. When we get into our car, we put our seat belt on, adjust the mirrors, and follow the “rules of the road” always looking to for the crazy driver in our rear view mirror. When we gas up the car, we check the tires and sometimes we might check the oil and fluid levels. Why? Because we know that these measures reduce the risk of accident or road-side breakdown.
And if we have children, we multiply this by 10! We are always looking for what could injure our precious bundles of “out-of-control” joy!
Risk Mitigation of Events:
We can respond to risk in these 4 ways below if we take driving a car as an example:
Avoid it: (don’t drive in a car)
Manage it: (use your seat belt | keep your car tuned up | look both ways | listen to traffic reports | obey highway laws | have auto insurance)
Transfer it: (hire a driver or take cabs)
Accept it: (jump in the car and hit the accelerator!)
So the first thing on developing a risk management strategy is to properly DEFINE the risk first. If you get that wrong it is unlikely you will find a solution that will work.
Risk Mitigation over a lifetime:
See if this makes sense to you. In order of frequency, you get sick | incur an injury | have a fender-bender | have an operation in the hospital | become disabled and cannot work for a period of time | require long term care | have a heart attack and die. But chances are that all of these things will not happen to you. You just might avoid most of this, and live to be over 90 years old. There are various types of insurance policies (health | auto homeowners | disability | long term care | life) that can cover the expenses incurred because of a lifetime event. You can also reduce risk by modifying your behavior. You can eat nutritious food, exercise, involve yourself with activities that stimulate your brain, and find companionship so that you are not alone without help. As you get older, you can downsize to a single level dwelling, secure the rugs, and place hand railings where you need them.
Risk Definitions with Investments:
Portfolio managers and raving analytical people (like me) obsess with defining and managing investment risk to protect portfolio assets. Here is a detailed list of what is involved here. The purpose of sharing this with you is NOT for you to do this but to appreciate and be working with a designated professional who will do this for your investment portfolio. Most financial advisors have a team of investment management firms that specialize in risk management analysis. Think of it as the “insurance policy” that is protecting your portfolio.
Types of Risk:
Systematic (Non-diversifiable) Risk (5 types)
Systematic risk is composed of risk types that reflect broad economic activity, are market related, and affect all similar types of investments. These risks cannot be eliminated within their own asset class and
therefore are said to be non-diversifiable. It is non-diversifiable in that adding more issues to a certain asset class cannot diversify away that risk. For example, adding 10 more bonds to a portfolio of, say, 20 bonds will not diversify away interest rate risk or purchasing power risk (explained below). However, within the context of a portfolio, those risks can be mitigated with the addition of different assets. To take a second example, if the 20-bond portfolio is changed to a portfolio of 50% bonds and 50% stocks, the portfolio’s purchasing power risk can be lessened because, over time, stocks outperform inflation. Systematic risk includes the following types, and can be remembered with the acronym “PRIME”:
Purchasing power risk | Reinvestment risk | Interest rate risk | Market risk | Exchange rate risk
Purchasing power risk.
Return may not keep pace with inflation.
Dividends produced may not earn as high a rate
Interest rate risk.
Bond values drop as interest rates increase.
Longer bond maturities and lower coupon rates change the NAV in response to changing interest rates.
Securities tend to rise and fall in unison.
Exchange rate risk.
Currency values can have an adverse affect on the value between U.S. and foreign currencies.
A weak U.S. dollar benefits U.S. investors who own foreign securities.
Unsystematic (Diversifiable) Risk (10 types)
Unsystematic risk, also called diversifiable risk, describes risk factors specific to an individual investment. Factors such as a company’s management (both ability and credibility), financial structure, earning power, fundamental business plan, patents, product line, position within its industry, and marketing strengths are just some of the specific aspects that can impact the risk of an investment. It is called diversifiable risk because these risks can be diversified away in a portfolio of several different stocks in several different industries. Unsystematic risks include the following types; it is especially important to understand business and financial risk.
Company management, product line, marketing ability, earnings, dividends, and other factors specific to
that company or industry contribute to business risk.
Businesses financing using stock (equity) has no financial risk.
Businesses financing using loans (debt) has financial risk.
Defaulting on company bonds, commercial paper, leases, and loans
A company’s default risk is reflected in its credit rating
Unstable political, economic, or social structure of a country can lead to the manifested
in the expropriation of assets, exchange control laws, the overthrow of governments, war,
corruption, and riots. Funds tend to flow into the United States as a safe haven for wealth.
Liquidity and marketability risk.
Liquidity is measured by how quickly asset principal can be converted to cash.
The less liquidity an investment has, the more liquidity risk it has. Liquidity and
“marketability” are frequently used synonymous but does not necessarily imply investors
would have difficulty obtaining their money. Mutual funds and stocks listed on the New York
Stock Exchange are considered very liquid. Office building are illiquid.
Call risk is the possibility that a debt security will be called in by its issuer prior to maturity.
Call risk increases when interest rates decline.
Event risk (mostly bonds) can be triggered by an unanticipated and damaging event. The event
may take the form of a major tax or regulatory change; a change in a company’s capital structure
due to a merger or buyout; disclosure of fraud or other significant misdeeds; negative media
attention to a particular product; or a major, unexpected event. Municipal bonds can experience
event risk as well. For example, in 1993 and 1994 the treasurer of Orange County*, California,
invested in derivative securities, which eventually caused large, unexpected losses. This, in
turn, caused a large selloff of the county’s bonds due to serious questions about the county’s ability to pay back the losses. (*the county declared bankruptcy on December 6, 1994, due to $1.7 billion of losses from these derivatives).
The misinterpretation of tax laws and regulations for tax strategies or derivatives can place the investor
at risk to back taxes, interest and penalties.
Investment manager risk.
Investment managers of mutual funds, separately managed accounts and hedge funds may under perform
Fraud risk such as the Bernard Madoff “Ponzi” scheme gets its name from Charles Ponzi, who offered investors
unrealistic high returns and accomplished this by paying off old investors (and himself) with money coming in from new investors. Unfortunately, there have been numerous scams that have come to light recently, and this has given the financial services industry a black eye. This has raised concerns by many individuals whether there is adequate regulation and protection for investors.