Common Methods of Measurement for Investment Risk Management

Risk management is a crucial process used to make investment decisions. The process involves identifying the amount of risk involved in an investment, and either accepting that risk or mitigating it. Some common measures of risk include standard deviation, beta, value at risk (VaR) and conditional value at risk (CVaR).

Standard deviation measures the dispersion of data from its expected value. The standard deviation is used in making an investment decision to measure the amount of historical volatility associated with an investment relative to its annual rate of return. It indicates how much the current return is deviating from its expected historical normal returns. For example, a stock that has a high standard deviation experiences higher volatility, and therefore, a higher level of risk is associated with the stock.

Beta is another common measure of risk. Beta measures the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market. The market has a beta of 1, and it can be used to gauge the risk of a security. If a security's beta is equal to 1, the security's price moves in time step with the market. A security with a beta greater than 1 indicates that it is more volatile than the market. Conversely, if a security's beta is less than 1, it indicates that the security is less volatile than the market. For example, suppose a security's beta is 1.5. In theory, the security is 50 percent more volatile than the market.

Value at Risk (VaR)

Value at risk (VaR) is a statistical measure used to assess the level of risk associated with a portfolio or company. The VaR measures the maximum potential loss with a degree of confidence for a specified period. For example, suppose a portfolio of investments has a one-year 10 percent VaR of $5 million. Therefore, the portfolio has a 10 percent chance of losing more than $5 million over a one-year period.

Conditional value at risk (CVaR) is another risk measure used to assess the tail risk of an investment. Used as an extension to the VaR, the CVaR assesses the likelihood, with a certain degree of confidence, that there will be a break in the VaR; it seeks to assess what happens to an investment beyond its maximum loss threshold. This measure is more sensitive to events that happen in the tail end of a distribution – the tail risk. For example, suppose a risk manager believes the average loss on an investment is $10 million for the worst one percent of possible outcomes for a portfolio. Therefore, the CVaR, or expected shortfall, is $10 million for the one percent tail.

Beyond the particular measures, risk management is divided into two broad categories: systematic and unsystematic risk.

Systematic Risk

Systematic risk is associated with the market. This risk affects the overall market of the security. It is unpredictable and undiversifiable; however, the risk can be mitigated through hedging. For example, political upheaval is a systematic risk that can affect multiple financial markets, such as the bond, stock, and currency markets. An investor can hedge against this sort of risk by buying put options in the market itself.

Unsystematic Risk

The second category of risk, unsystematic risk, is associated with a company or sector. It is also known as diversifiable risk and can be mitigated through asset diversification. This risk is only inherent to a specific stock or industry. If an investor buys an oil stock, he assumes the risk associated with both the oil industry and the company itself.

For example, suppose an investor is invested in an oil company, and he believes the falling price of oil affects the company. The investor may look to take the opposite side of, or hedge, his position by buying a put option on crude oil or on the company, or he may look to mitigate the risk through diversification by buying stock in retail or airline companies. He mitigates some of the risk if he takes these routes to protect his exposure to the oil industry. If he is not concerned with risk management, the company's stock and oil price could drop significantly, and he could lose his entire investment, severely impacting his portfolio.