Risk management is a very important process in making decisions for your investments. This process includes identifying and analyzing the amount of risks involved in an investment. In this process, you either accept the risk or mitigate it. And the following are some of the most important measures of risk used in risk management.
Standard Deviation
Standard deviation measures the dispersion of data from its expected value. This measure 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.
In other words, this gauge measures how much the current return is deviating from its expected historical normal returns.
Beta
Beta is another common risk measure. It gauges the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market.
The market sports a beta of 1, and it can be a benchmark to measure the risk of a security. If a security’s beta is equal to 1, this means the price movement is in lockstep with the market. If the beta is greater than 1, the security is more volatile than the market. On the flipside, if the beta is less than 1, this means the security is less volatile than the market.
Value at Risk (VaR)
Value at Risk (VaR) refers to a statistical measure that analysts use to assess the level of risk associated with a portfolio of a company.
The VaR measures the maximum potential loss with a degree of confidence for a specified period. For instance, when they say that a portfolio has a one-year 10% VaR of $5 million, they mean it has a 10% chance of losing more than $5 million during a one-year period.
Conditional Value at Risk (CVaR)
Conditional Value at risk (CVaR) refers to another risk measurement that assesses the tail risk of an investment.
As the name implies, it is an extension of VaR. The CVaR measures the chance, with a certain amount of confidence, that there will be a break in the VaR. It aims to assess what happens to investment beyond its maximum loss capacity. This measure is more reactive to events that happen at the tail end of a distribution.
Risk Management Categories
Apart from those measures, risk management can be categorized into two: systematic and unsystematic.
Systematic risk is linked to the market. The risk affects the entire market of the security. Also, it’s unpredictable and undiversifiable. As a result, the risk can only be mitigated through hedging.
Meanwhile, unsystematic risk refers to the risk associated with a company or a particular sector. It is considered as a diversifiable risk and investors can mitigate it through asset diversification.
This risk is only inherent to a specific stock or industry. For instance, if an investor buys the stock of a company that deals with the oil market, he or she is assuming the inherent risks linked to both the stock and oil market.
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