What is Risk Management?？

In the definition of financial markets, risk management is the process of clarifying, analyzing, accepting and mitigating investment uncertainty.。Essentially, when an investor or fund manager analyzes and attempts to quantify investment losses, he or she takes action based on set investment objectives and risk-taking capabilities。

Risk and reward are inextricably linked, and almost all investments carry risk, except that this risk is either large or small, for example, investing in government bonds is low risk, but investing in emerging market equities is high risk.。

Basically every investment has its own relative risk, so it's important to have a deep understanding of risk so that investors can better understand the opportunities and costs that different investment approaches can bring.。

If the risk management is not good, it will bring investors and even the economy very serious consequences, such as the outbreak of the subprime mortgage crisis in 2008, causing the global stock market crash, is because the U.S. government made a very wrong risk management strategy, let the market mistakenly believe that the housing market is very optimistic, and the real estate securitization, coupled with the easing of lending policies and the laxity of rating agencies.

What is the expectation？

The expected value is the expectation of something to happen in the future, in either case, when the result has deviated from the expected value, and the range of how much it deviates is often called the error, which in statistics is also called the standard deviation.。

Back to the stock market, assuming that the average return on the stock market is 10%, this 10% is the expected value, and the real result of the investment has a high probability is not 10%, that the distance from the expected value, the range is calculated as the standard deviation, the standard deviation in the stock market can be used as the instability of investment compensation.。

The market definition of investment risk is the deviation from the true result, the so-called standard deviation。The standard deviation may be positive or negative, and the investment community believes that the standard deviation means the expected result to be achieved to some extent, thus deriving the statement "the higher the risk, the higher the reward," which, to put it bluntly, is actually "in order to get a higher return, investors are willing to take a higher risk to achieve the desired result," in fact, high risk is not equal to high return。

When the standard deviation is larger, it means that the true result is more distant from the expected value and the return on investment is more volatile, which is the so-called greater investment risk.。When the standard deviation is smaller, it means that the smaller the true result is from the expected value, the more stable the return on investment is, which means that the less risky the investment is.。

So the purpose of risk management is actually to reduce this standard deviation, as long as you control the standard deviation, you can make the return on investment more stable.。

investment risk classification

Systemic Risk

Systemic risk refers to the risk that will arise throughout the market, which is the kind of risk that can't be stopped no matter what, such as financial turmoil, economic collapse, natural disasters, war, politics and so on, which can affect the general environment, and is often the source of systemic risk.。

Take the financial turmoil as an example, when the financial turmoil occurs, all kinds of targets are often down, no matter how good companies you invest in, how good the fundamentals of the stock are not immune, even if the diversification of investment can not balance the investment risk, can only watch the investment losses。

How to reduce systemic risk?？To be honest, it's almost impossible to prevent the entire market environment from being changed, and although it's just been said that diversification won't help, all investors can do at this point is diversify their assets and reduce volatility as much as possible.。

non-systematic risk

Unsystematic risk refers to the risk of stocks, or other single commodity risk, is a risk arising from the business conditions of an enterprise, such as enterprise A's poor financial results, high-level fraud, the emergence of competitors, asset damage, etc.。

One of the characteristics of unsystematic risk is that the risk of a single firm is not framed to another firm and the market, because there is no relationship between the two firms, and that risk is not implicated.。

Does investment risk always exist?？

When it comes to risk, many investors' intuition is negative, that risk is not good, but in fact, as long as there is in the investment field, there must be risk, it is a necessary element of the investment field, and even inseparable from the relationship between compensation。

Leaving aside the stock market and other investment instruments, even if you invest in an ETF that is recognized as low risk, you may experience a market crash that will cause the ETF to lose money; even if you don't invest in anything, just keep your assets in the bank for fixed deposits, you have to worry about whether the bank will fail one day and not get your assets back, although the probability of this risk is minimal, but it is a risk;。

So no matter what you do, the risk is always there, and what investors should do is to recognize it and manage it, so that they can adjust the risk to the level that is best for them.

Investment Risk Management and Psychology

Behavioral psychology has contributed a very useful piece of information to investment risk management, which tells us that there is an asymmetry in the way the average person looks at making and losing money.。

In 1979, behavioral scientist Amos Tversky and psychologist Daniel Kahneman jointly found that investors face the pain of loss is twice the happiness of profit, in other words, the pain of losing a dollar is twice the happiness of earning a dollar, people are more afraid of losing money to get pain than making money to get happiness, this psychological phenomenon is called "loss aversion (loss aversion)."。

The standard deviation has positive and negative, if the following chart, assuming that the middle line is the expected value, on the right side of the expected value is to make money, on the left side is to lose money, then loss aversion will occur in the left area, the left Y-axis is longer than the right Y-axis, showing that investors have a negative attitude towards losing money than making money.。

It is precisely because investors are afraid of losing money, so they have to face up to the risk, if the risk is well controlled, the investment has the opportunity to reduce losses, so that the degree of loss aversion is greatly reduced, and then the better result is, of course, to make money.。

Relationship between Beta and Risk Management

Beta (beta) can be used to measure systemic risk, and each stock has its own beta, which is used to represent the volatility of the commodity relative to the market as a whole, thereby assessing systemic risk。

If the beta value is greater than one, it means that the systemic risk of this commodity is greater than the market and the price volatility is large; if the beta value is less than one, it means that the systemic risk of this commodity is smaller than the market and the price volatility is small; if the stock A vs NASDAQ is equal to one, it means that the performance of stock A is exactly equal to the NASDAQ index.。

But the beta value can only be used as reference data, and can not be used as the only risk quantification criteria, because even if the beta value is large, it can also mean that when the market is good, the commodity will rise better than the market, of course, if the market is not good, it may fall more than the market.。If the beta value is small, which means that the stock is relatively conservative, then whether the market is good or bad today, the stock price will fluctuate less than the market.。

There are many reasons for this result, inflation, policy, economic changes, etc. may be factors, although this does not prove that stocks with small beta values are less volatile than the market, but it also laterally proves that stocks with small beta values are indeed less volatile and are relatively low-risk investment targets.。

The relationship between alpha and risk management

Alpha value (alpha value) can be used to assess the risk of a single commodity (also known as unsystematic risk), when the higher the alpha value, represents a chance to get better compensation after deducting systematic risk, assuming that the market index falls by 5%, companies with good alpha values may only fall by 3%, when the market index rises by 5%, companies with good alpha values may rise by 7%, and there may be a relationship behind this result.。

This is what most investors will pursue: identifying stocks that offer excess compensation, and if investors see more potential for technology stocks in the S & P 500, they can focus their portfolios on technology stocks, which may have potentially high alpha values。

The change factors of alpha value are usually related to the financial reporting status, operating status, management status and other company-oriented, and because of this, alpha value is very difficult to quantify, there have been studies to simulate a model, but due to a bit of complexity, coupled with the situation of each company is inherently different, here is not much to repeat, but in short, the alpha value of good fundamentals of the company is usually not bad, so as long as you find the right。

4 Major risk management strategies

Diversification

Diversification can be said to be a very classic strategy in risk management, the stock market is often heard "don't put eggs in the same basket" is talking about diversification, that is, don't concentrate assets in a certain target or market, but to spread them out, so as to spread the risk。

In addition, diversification can reduce the loss aversion mentality, because investors hate losses, so to diversify the stock elsewhere, so that even if a target or market falls, it will not lose too much, the degree of loss aversion will be slightly alleviated.。

Basically, the practice of diversification is very diverse, investing in.

• Stocks + Bonds
• Traditional Industry + Emerging Industry
• Large Cap Companies + Small Cap Companies
• Emerging Markets + Mature Markets
• Growth + Value Stocks

There is a classic portfolio in the U.S. stock market, which basically perfectly explains what diversification is, called "The All-Weather Portfolio (The All-Weather Portfolio)," of which 30% are stocks, 40% are long-term bonds, 15% are medium-term bonds, and 15% are other commodities.。

The original purpose of the all-weather portfolio was to do a good job of risk management philosophy, it is not primarily to maximize the return on assets, but to achieve a balance between the risks of different asset classes, in order to achieve a portfolio that can withstand market fluctuations and produce long-term stable returns.。

periodic quota

One of the factors in the movement of the stock price of the investor's sentiment, many people in the market will hear a certain market news, they rush to make investment decisions, such as the financial report came out and found that revenue is not as good as expected, causing investors to rush to sell, but do not know is the company's future outlook is very good, now sold can not wait for the future rise。

Investors can't predict the news in the market, let alone the timing of entry and exit, which creates risk, so they have to set regular quotas, which means investing a fixed amount of money over a fixed period of time.。

Invest in reliable companies

Good fundamentals, good management, and good growth potential are all symbols of good companies, and these companies usually don't have bad alpha values, so by investing in good companies, you've basically been able to avoid most of the unsystematic risks.。

For example, Apple (code name: APPL) continues to grow in revenue and net income, has excellent corporate governance, has hardly heard of management scandals, and is a company that is constantly pursuing innovative technologies, which is a great company for most investors.。

Long-term investment

In the long run, the stock market is continuously rising, as long as one day does not give up investment, there is a chance to wait until the day of success。Another stock market quote "buy low and sell high" set in the long-term investment will have better results, in the long run, the stock market will fall every few years, this decline is inevitable systemic risk。

Take a look at the S & P500 from 2008 to the end of 2019:

After falling from 2008 to its lowest point in early 2009, the S & P500 has continued to rise from 735 to 3,230 at the end of 2019, and if there were investments in U.S. stocks during the subprime crisis, it would have essentially doubled several times by 2019.。

Take another look at the S & P500 performance from early 2020 to early 2023:

The three-year period included the outbreak of the new crown epidemic to the global lifting of the ban, the S & P500 also fell from the outbreak to 2304 points (2020 / 03 / 16), and then continued to rise until 2023 / 01 / 30 to 4136 points, a growth of nearly 80%, if there is an entry into the index in early 2020, assets should also increase by 80% in 3 years。

The above two examples fully demonstrate what is meant by the benefits of long-term investment, which, in addition to demonstrating that long-term investment returns are good, also demonstrate that long-term investment can eliminate systemic risk.。

SUMMARY

To summarize briefly, risk management refers to the "process of clarifying, analyzing, accepting or mitigating investment uncertainty," which, if properly managed, has the opportunity to reduce losses and make investment returns more stable.。