This reading will focus on economic and financial risk as it relates to investment management.
All businesses and investors manage risk in the choices they make, even if not conciously. Business and investing are about allocating resources and capital to chosen risks. In their decision process, businesses and investors may take steps to avoid some risks, pursue the risks that provide the highest rewards, and measure and mitigate their exposure to these risks as necessary. Risk management processes and tools make difficult business and financial problems easier to address. Risk is not just a matter of fate; it can be actively controled with decisions, within a risk management framework. Risk is an integral part of the business or investment process. Even in the earliest models of modern portfolio theory, such as mean–variance portfolio optimization and the capital asset pricing model, investment return is linked directly to risk but requires that risk be managed optimally. Proper identification and measurement of risk, and keeping risks aligned with the goals of the enterprise, are key factors in managing businesses and investments. Good risk management results in a higher chance of a preferred outcome—more value for the company or portfolio or more utility for the individual.
Portfolio managers need to be familiar with risk management not only to improve the portfolio’s risk–return outcome, but also because of two other ways in which they use risk management at an enterprise level. First, they help to manage their own companies that have their own enterprise risk issues. Second, many portfolio assets are claims on companies that have risks. Portfolio managers need to evaluate the companies’ risks and how those companies are addressing them.
This reading takes talks about the risk management of enterprises in general and portfolio risk management. The principles underlying portfolio risk management are generally applicable to the risk management of financial and non-financial institutions as well.
The concept of risk management applies to individuals. Although many large entities formally practice risk management, most individuals practice it informally and disorderly, oftentimes responding to risk events after they occur, and they ignore more subtle risks often. Many individuals simply do not view risk management as a formal, systematic process that would help them achieve not only their financial goals but also the ultimate end result of happiness, or maximum utility as economists like to call it, but they should.
Although the primary focus of this reading is on institutions, we will also cover risk management as it applies to individuals. We will show that many common themes underlie risk management—themes that are applicable to both organizations and individuals.
Although often viewed as defensive, risk management is a valuable offensive weapon in the manager’s arsenal. In the quest for preferred outcomes, such as higher profit, returns, or share price, management does not usually get to choose the outcomes but does choose the risks it takes in pursuit of those outcomes. The choice of which risks to undertake through the allocation of its scarce resources is the key tool available to management. An organization with a comprehensive risk management culture in place, in which risk is integral to every key strategy and decision, should perform better in the long-term, in good times and bad, as a result of better decision making.
The fact that all businesses and investors engage in risky activities (i.e., activities with uncertain outcomes) raises a number of important questions. The questions that this reading will address include the following:
What is risk management, and why is it important?
What risks does an organization (or individual) face in pursuing its objectives?
How are an entity’s goals affected by risk, and how does it make risk management decisions to produce better results?
How does risk governance guide the risk management process and risk budgeting to integrate an organization’s goals with its activities?
How does an organization measure and evaluate the risks it faces, and what tools does it have to address these risks?
The answers to these questions collectively help to define the process of risk management.