According to the Cambridge Dictionary, risk is the possibility of something terrible happening. This is how most people think of it, i.e. as a downside or the potential for loss. In this article, we’ll specifically explain market and investment risk.
In this example, we “lose” if we get hit by a car (that’s the risk). The outcome can be a partial loss (we get injured) or losing everything (we perish).
Of course, deciding which street to cross will significantly impact your chance of safely crossing. If you cross an autobahn in Germany, your risk of an accident is high, while if you cross a supervised crossing on a small suburban street, you’re likely to make it safely over.
The latter can be compared to investment risk: choosing which street to cross because not all roads are the same risk.
Taking the example one step further, the market risk is the overall threat of pedestrian crossings. As cars in the past have gotten better breaks and tyres, their drivers have become more likely to be able to stop in time for a pedestrian. The same goes for adding signs (and sometimes lights) at crossings. Cars are now equipped with Artificial Intelligence to help drivers identify pedestrians and avoid accidents.
All these factors lower the probability of pedestrians' injuries and deaths in traffic, which can be seen as lowering the risk of accidents in “the market of street crossing”.
When investing, there is an upside, not just a downside; a stock or commodity price can be higher or lower tomorrow compared to today. But beyond this difference, the market risk is similar to the that of crossing a road.
To manage market risk, we can:
Before we know how to deploy either of these approaches, it’s useful to have a measure of the risks in the financial markets. Based on those measurements, we can decide an acceptable level of market risk we want to take with our investments.
The most common measure of risk is volatility, which is defined as:
How much will the price of an asset move, with 68% probability?
Yes, that is a strange definition. The 68% might seem very exact, but it comes from natural observations. Here is a Wikipedia page that digs deeper into distributions if you’re interested.
The benefit of this approach is that we can easily compare two stocks or different asset classes. If stock A has 20% volatility and stock B has 10%, we can easily understand that stock A's risk (and upside) is double compared to stock B.
The shortcoming of the simple volatility measure is that it doesn’t consider extreme events. A measure developed to address that issue is Value-at-Risk (VaR). VaR measures how much a particular asset will lose in value, with a certain probability (usually 95%).
In simpler terms:
Value-at-Risk (VaR) measures how much an asset will likely lose
on its worst day in a given month.
Now that we know two ways to measure risk, we can consider reducing it in our portfolio. The most common and obvious way is diversification: adding multiple different assets into the portfolio with the argument that commodity risk, foreign currency risk, interest rate risk and stock market risk are different. On a day when one asset declines in value, others move up.
The problem with this approach is that stressed markets often simultaneously strikes many types of investments in the same direction. So, while investment risk (of a single asset) and market risk are different, each investment will have a level of systematic risk in it.
We hope this article has been useful in understanding what market and investment risk is, and how it can be measured. At Limina, we help investment managers worldwide manage their workflows from the Front to the Middle Office. We help reduce both operational risks and to measure and control investment risk.