RISK

Investors frequently guide their portfolio strategies and investment choices by their return objectives, by how much they want, or need to earn. But return objectives are only one piece of the puzzle - and not the most important piece - in determining investment guidelines. Investors must understand their risk position and how that risk position can be matched with a suitable investment portfolio.

Managing risk requires knowing the answers to three set of questions.

1. The investor’s risk position
   1. The minimum required risk exposure – how much risk does the investor need to meet return requirements
   2. The maximum risk limit – what is the maximum risk an investor can prudently assume before loss probabilities threaten investor viability or long-term goal achievement?
   3. The investor’s risk tolerance – how much variability can the investor tolerate psychologically?
       
2. Investment portfolio risk
   1. Portfolio risk assessment – what is the overall risk of a portfolio and how is it measured?
   2. The role of diversification – how can assets be combined to reduce portfolio risk?
   3. Risk insurance or mitigation – what other strategies can investors use besides diversification to manage risk?
       
3. Capital markets risk
   
   1. The nature of investment risk – how are risk and return related?
   2. Asset risk – what are the risk/return profiles for assets that investors can use to build a portfolio?
   3. Correlations – how do various assets perform relative to each other?
   4. Extremes – how can investors manage the impact of extreme events in capital markets?

Unless an investor has some idea about how to answer these questions, the investor – whether an individual or an organization – is likely to suffer from too much risk or from too little return from its investments.

For articles that address these questions, see the Risk Management content page.