Risk management is used in all industries to mitigate the probabilities of the loss of assets. Risk management identifies, evaluates, and prioritizes the frequency and magnitude of the potential probabilities of risk events. Risk management implements cost effective processes to use available resources to measure, minimize, and limit the impact and damage of both common and rare events while maintaining the chances for profitable opportunities. Negative events lead to losses and are quantified as risks and positive events that lead to profits are classified as opportunities. A risk management process tries to minimize risk exposure while not interfering with maximizing rewards. Risks are always present and arise throughout the life cycle of a trader, investor, or business.
Here are different types of risks to manage for:
- Uncertainty of outcomes in financial markets
- Failures of execution of a plan
- Design error
- Program error
- Human error
- Managing business cycles
- Credit risk
- Natural disasters
- Political risk
A risk management method needs to be developed to fit the context of the user. Investors use it for financial portfolios while traders use it for active trades and positions.
One of the main strategies to manage for risk and the uncertainties of negative outcomes is to avoid any unnecessary risk exposure or limit the loss or probability of the risk that is necessary by limiting the size of the exposure to any one risk. Also transferring risk or some of it to someone else by buying a hedge or insurance is one of the most basic elements of risk management. The opposite of risk management is full exposure to an opportunity with no limit to the potential size of a loss if it doesn’t play out the way that it is expected.
The most difficult part of risk management is to not be caught with too much exposure to loss in a rare Black Swan event but also manage profits in normal White Swan functioning markets from day to day.
A risk management method uses the following processes in this order, most the time:
- Identify the risks that can cause losses.
- Quantify the exposure of assets to the potential risks.
- Understand the magnitude of risks in different scenarios.
- Create ways to manage, limit, and reduce risk exposure.
- Assign levels of importance to different risk reduction processes.
- Implement risk management plan and processes.
The principles of risk management:
- It should create value by the cost of risk management being less than the cost of the risk events.
- It should be an embedded part of profitable processes.
- It should be a filter used as part of decision making.
- It should manage for uncertain events, opinions, and predictions not working out based on expectations.
- Risk management should be a system with a quantified process.
- A process for managing risk should be based on historical data and the probabilities of future data.
- Risk management must be based on specific risk tolerance and return goals.
- It must accept the risk of human emotions, egos, and irrationality causing outsized events.
- The management of risk should be dynamic, reactive, and flexible to adjustments.
- The risk management process should be regularly reexamined for learning, improving, and changing with the environment.
The purpose of risk management is to keep losses small, eliminate the risk of ruin, and still keep the potential for profitability open.
To learn more about risk management in trading and investing here is a link to my full risk management book here.