By David Adonri, Executive Vice Chairman, Highcap Securities
The capital market is, generally, regarded as a safe haven for investment. There, your money works for you. The market is a setting for income without stress. Smart and daring speculators can make fortunes there and can also lose a fortune through poor judgement.
Despite its attractiveness, the capital market is volatile. In fact, volatility in price of securities is the hallmark of every capital market. Increased risk can emanate from increased volatility. Everyday, stock prices go up and down in reaction to any number of issues involving business, the socio-economy and geopolitical events. The field of behavioural science has contributed an important element to the risk equation, demonstrating asymmetry between how investors view gains and losses. Investors usually put roughly twice the weight on the pain associated with loss than the good feelings associated with a profit. Every investor wants to play safe with his investments. Often, investors want to know just how much the value of an asset may deviate from it’s expected outcome, and also how bad things may look way down on the negative side. Value-at-Risk (VaR) attempts to provide an answer to this question. The idea behind VaR is to quantify how large a loss in investment could be with a given level of confidence over a defined period.
Due to the high volatility and frequent downturns in the capital market, uncertainties characterize the predictability of returns on investment. As a result of uncertainty, it is extremely difficult to predict the future price of a security and by extension, direction of the capital market. Uncertainty and risk are synonyms but they are not quite the same. Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never really been properly separated. The term “Risk” as loosely used in everyday speech and in economic discussion, really covers two things which functionally at least in their causal relations to the phenomenon of investment, are categorically different.
Uncertainty is the lack of complete certainty. It is a situation where the future outcome cannot be predicted with any confidence from knowledge of past or existing events. Uncertainty presents more than one possibility whereby the true outcome or result is unknown. Uncertainty is immeasurable ie, not possible to calculate whereas, risk is a state of uncertainty where some of the possibilities involve a loss, catastrophe or other undesirable outcome. It is a set of possibilities each with quantified probabilities and quantified losses. One may have uncertainty without risk but not risk without uncertainty. We can be uncertain about the winner of a contest but unless we have some personal stake in it, we have no risk. If we bet money on the outcome of the contest, then we have a risk. Consequently, the measure of uncertainty refers only to the probabilities assigned to outcomes while the measure of risk requires both probabilities for outcomes and losses quantified for outcomes. Uncertainty presents both risk and opportunity, eroding or enhancing value.
Risk is the degree of uncertainty associated with a return on an asset. Risks are simply future issues that can be avoided or mitigated, rather than present problems that must be immediately addressed. Financial investment risk is often defined as the unexpected variability or volatility of returns and this includes both potential worse – than – expected as well as better – than – expected returns. In statistics, risk is often mapped to the probability of some events seen as undesirable. Usually, the probability of that event and some assessment of it’s expected harm must be combined into a believable scenario (an outcome), which combines the set of risk, regret and reward probabilities into an expected value for that outcome.
Risk concerns the deviation of one or more results of one or more future events from their expected value. It is a function of possible loss amounts each associated with specific probabilities. Technically, the value of these results may be positive or negative. General usage tend to focus only on potential harm that may arise from a future event which may accrue either from incurring a cost (downside risk) or by failing to attain some benefit (upside risk). While we tend to think of risk in predominantly negative terms, however, in the investment world, risk is necessary and inseparable from desired performance. Risks are just situations where occurrence of a particular event can be postulated with some degree of confidence from the knowledge of past or existing events. Risky events are predictable and foreseeable only within the existence of some degree of confidence.
A fundamental idea in finance is the relationship between risk and return. The greater the potential return one might seek, the greater the risk that one generally assumes. The capital market reflects this principle in the pricing of a security; strong demand for a safer security drives it’s price higher (and it’s return proportionately lower), while weak demand for a riskier security drives it’s price lower (and it’s potential return thereby higher). For example, an FGN bond is considered to be one of the safest investments and when compared to a corporate bond, provides a lower rate of return. The reason for this is that a company is much more likely to go bankrupt than the Federal Government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return. Every investment involves some degree of risk, which is considered close to zero in the case of FGN bond and bills, or very high for something like junk bonds in inflationary markets. Consequently, a good understanding of risk in it’s different forms can help investors to better understand the opportunities, trade-offs and costs involved with various investment approaches.
Risk in the capital market is real. All investments in the capital market in various securities carry risks because the future expected returns are surrounded with uncertainty. The stark potential of experiencing losses, following a fluctuation in security prices is the reason behind capital market risk. When a person is investing in a security, the risk and return cannot be separated. Risk differentiates an investment from ordinary savings. Some investors have high risk tolerance and are relatively unshaken by even steep market declines. For others, a small pull back in value of their investments can cause sleepless nights.
Risks in the capital market are categorized into two broad classes. These are systematic and unsystematic risks. Systematic risks arise from various risks emanating from the geopolitical and socioeconomic environment where government and businesses operate. This risk affects all securities equally. It represents the risk free rate in the “Capital Assets Pricing Model” (CAPM). Because systematic risk affect all securities, it cannot be diversified away. It presents itself in the capital market as the overall risk or market risk. It shapes the collective view of investors to invest in a particular stock thus, playing a significant role in the rise or fall of the entire capital market. Even if a company is going through problems, its stock price may rise due to a generally rising stock market. The reverse is also possible. Investors usually face this general risk. Underlying market risk are inflation risk, interest rate risk, currency risk, political risk, hazard risks (natural disasters, war, pestilence etc), liquidity risk etc. Unsystematic risk on the other hand, is the risk caused by unique factors of a particular organization or security. Under CAPM, it represents the risk premium a security attracts after the risk free rate has been provided for. The higher the unsystematic risk, the higher the risk premium demanded by investors. Underpinning unsystematic risks are industry risk, business risk, regulatory risk etc. Industry risk affects all the enterprises operating in a certain industry. Business risk may affect the investor if the company goes through some convulsions depending on management, strategies, market share and labour disputes. Recently, cyber risk has also become an issue due to rampant cyber attacks leading to corporate losses.
The total risk of an investment are both the systematic and unsystematic risks. Both of them are manageable. The ability to price risk opportunity identified, differentiates a successful capital market player from rest of the crowd. Risk management enables the investor to deal effectively with uncertainty and hence, associate risk with opportunity. Maximization of risk adjusted returns compel investment managers to invest heavily in risk management applications, to calculate investors maximum potential exposures.
When an investor steps into the capital market, the first step in risk management is profiling to ascertain his or her risk tolerance level. Next is to ascertain his or her investment objective(s) and match it / them with the risk tolerance, so as to assemble a suitable portfolio of assets. An investor’s risk appetite is set at a level that minimizes erosion of earnings or diminution of capital due to avoidable losses. Risk management is vital for investment decision making in order to optimize risk adjusted returns. It is simply a practice of systematically selecting cost effective approaches for minimizing the effect of threat realization to the investment. All risks can never be fully avoided or mitigated simply because of financial or practical limitations. Therefore, investors have to accept some level of residual risks. Risk management is preemptive and it involves the identification, assessment and prioritization of risks, followed by coordinated and economical application
of resources to minimize, monitor and control the probability and / or impact of unfortunate events or to maximize the realization of opportunities.
Risk problems are related to identified threats. For example, the threat of losing money. When either source or problem is known, the events that a source may trigger or that can cause a problem can then be investigated.
Common risk identification methods are:
1) Objectives-based risk identification:- Investments have objectives. Any event that may endanger achieving an objective partly or completely is identified as risk.
2) Scenario-based risk identification:- In scenario analysis, different scenarios are created. The scenarios may be the alternative ways to achieve an objective or an analysis of the interaction of forces, in for example, a market. Any event that triggers an undesired scenario alternative, is identified as risk.
Once risks have been identified, they must then be assessed as to the probability that there are threats and vulnerabilities, their potential severity of loss and the probability of occurrence. These quantities may be either simple to measure, like in the case of the value of a lost building or impossible to know for sure as in the case of the probability of an unlikely event occurring. Therefore, in assessment process, it is crucial to make the best informed guesses possible in order to properly prioritize the implementation of the risk management plan. Some regard a calculation of the standard deviation of historical returns or average returns of a specific investment as providing some historical measure of risk. Example of risk management formula below is a statistical measure of dispersion around a central tendency, using standard deviations:
Risk is equal to rate of occurrence of event multiplied by impact of the event.
Risk assessment is quantitative. Qualitative assessment process is subjective and lacks consistency.
After identifying risks and assessing their impact on investment objectives, the strategies or techniques to respond and manage them falls into one or more of the following four major actions:
1) Avoidance (eliminate, withdraw from or not become involved).
2) Reduction (optimize – mitigate)
3) Sharing (transfer – outsource or insure)
4) Retention (accept and budget).
In ideal risk management, a prioritization process is followed whereby the risk with the greatest loss and the greatest probability of occurring are handled first, and the risks with lower probability of occurrence and lower loss are handled in descending order.
While systematic risk falls under the category that cannot be avoided but retained and budgeted for, unsystematic risks can be dealt with through efficient diversification, to reduce the total risk of a portfolio to the point where only systematic risk remains. As more randomly selected securities are added to a portfolio, unsystematic risk reduces at a decreasing rate approaching zero. The simultaneous purchase or sale of a financial instrument, known as hedging, can also specifically reduce or cancel out the risk in another investment. Also, through forwards, futures and options contract, several risks can be hedged to even magnify returns.
Finally, the key to managing risk is knowing your risk tolerance level that is consistent with one’s financial well-being, and invest accordingly. How will you react if your portfolio drops down by 10%, 20% or 30%? Are you prepared to accept significant volatility in exchange for more upside potential over time? Is your portfolio well diversified and allocated with a combination of stocks, bonds, commodities and cash equivalent investment choices? The answers to these questions can help you create a portfolio that meets your time horizon and tolerance for risks that can give you peace of mind.