The Importance of Risk Management in Finance Explained
Risk management is particularly important within the field of finance, and over time has become increasingly important for each and every player within the financial services ecosystem. During the 2008 Global Financial Crisis, many vulnerabilities in our risk management systems were uncovered. Since then, governments, financial services firms, and participants within the financial system have overhauled the way risk is viewed, assessed, and managed.
At the same time, with the advent of new technologies and securities such as artificial intelligence, machine learning, and cryptocurrencies, the way we manage risk must continue to evolve and get ever more sophisticated.
Risk management is important within the field of finance as the technology surrounding the field evolves, the tools used to manage risk must evolve as well.
Risk can be defined in many ways, including the risks associated with a particular investment or more broadly as the universe of risks faced by a financial services company (both internal and external).
Managing risk is important to avoid situations such as the 2008 Global Financial Crisis. Risk management is important to support a well-functioning economy and financial system.
What is Risk?
In order to highlight the importance of risk management, it is important to first understand what we mean by “risk.” Risk can be defined broadly as the possibility of loss or injury. In financial markets however, risk is typically more focused around investment risk – the probability that an investment’s realized outcome will differ from the outcome that is initially expected. This definition captures the main premise of risk, which is that when an investment is made, there is a chance that we may lose some or all of the investment depending on how risky that investment is.
Investment risk can be defined in several ways, including using:
Alpha: the risk that an investment strategy/portfolio will underperform relative to a related benchmark index such as the S&P 500.
Beta: the volatility of returns for an investment or portfolio relative to the broad market’s overall volatility.
Standard Deviation: the volatility of returns for an investment or portfolio relative to its mean return over a specific time period.
Sharpe Ratio: a measure of return as a unit of risk for an investment or portfolio over a specific time period to capture the return relative to the associated risk taken on to achieve the return.
While these are risks that strictly relate to financial performance and investing, there are other risks that are faced by financial services firms such as banks, insurance companies, and asset managers. These include:
Market Risk: the risk that losses may occur to financial assets based on the dynamics of the overall financial markets, for example an equity security losing a substantial portion of its value.
Credit Risk: the risk that a counterparty may default on their contractual obligations, for example an individual defaulting on their personal loan.
Liquidity Risk: the risk that funding obligations may not be met due to cash constraints, for example a bank not having enough cash on hand to meet deposit withdrawal demand.
What is Risk Management?
Risk management is the process of identifying, quantifying, and managing or mitigating potential risks faced.
Risk management is undertaken by all players within the financial services ecosystem, including investment managers, investment banks, retail banks, insurance companies, among others. These types of companies all have distinct financial exposures, regulations, and internal risks which they face.
Risk managers must quantify and analyze the potential for losses, and either accept, mitigate, or transfer the risk based on a decision process that they deem appropriate.
The Importance of Risk Management in an Investing Context
In the context of investing, there is a lot of the focus on generating returns. This is logical since the entire point of investing is to generate some sort of return on an initial investment. Asset managers, for example, commonly compete based on their ability to produce returns, and usually attempt to outperform a benchmark index. However, there is often much less focus on the risk that is taken on to achieve that return.
The relationship between risk and return is a fundamental principle of investing that is oftentimes overlooked, especially by retail investors. Many retail investors feel that if they have achieved a greater return than the benchmark, then they have created value.
The reality of the matter is that you cannot un-marry return from risk. A return should always be framed in the context of the risk that was taken on to achieve that return.
Let us imagine an investor who achieved a return that was twice the return of the benchmark but took ten times the risk to achieve that return. Would you consider this return attractive? On a risk-adjusted basis, it clearly is not. Conversely, imagine an investor who achieved a return that was half of the benchmark but took on no risk to achieve this return. That return is more attractive than it may appear at first glance.
Thank you for reading CFI’s guide to the Importance of Risk Management in Finance. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful: