It is virtually impossible to talk about investments without also talking about risk. The degree of risk that different investors are comfortable taking may vary widely, and the degree of risk of different investments may also vary widely, but risk is invariably present in the world of investing in some form or another. And of course, risky investments can yield generous payouts or can leave you wishing you hadn’t taken the risk in the first place. So, how do you perform a risk analysis in investments?
In other words, you want the perfect balance of an investment with just enough risk to potentially generate a huge reward, but not so much risk to break the bank. That’s a challenge to achieve, and there is no one easy answer because investors’ tolerance for risk varies so greatly. However, there is still plenty of advice we can give in terms of risk analysis and risk management for your investments.
What is Risk Analysis in Investments?
First, to better understand the process of risk analysis, let’s start with a definition. Risk analysis refers to the assessment of an adverse event occurring. Estimating the risk and return ratio of a given course of action is central to risk analysis.
Next, we want to discuss the differences between risk and volatility. Volatility is much easier to define than risk. It refers to the statistical measure of the dispersion of returns for a given index. Volatility is actually fairly easy to measure if you use the standard deviation of returns from the given index. The more possibilities of returns a given index has, the more volatility it has (because there are more possibilities than some of the returns will not be good).
Volatility is important to understand when thinking about risk because it is often confused with risk. The key distinction to remember is that just because an index is volatile does not necessarily mean it is risky. An index is risky to the degree to which it is possible that it underperforms, and/or that the investor loses capital.
The Process of Risk Analysis for Investments
Now that we have reviewed a few definitions, let’s delve into the process of analyzing risk. Ideally, anytime you are considering making an investment, one of the first steps you should take is to assess the risk. Assessing the risk of a given investment is essential in determining how worthwhile the investment is for your purposes. It will help you determine the expected outcome of the index, the return on investment, and much more.
Identify risk factors
The first step in risk analysis is to identify all the potential risk factors in a given index.
Next, using a probability metric, a risk analyst will weigh the likelihood of each of these potential risk factors occurring.
The last major component of a risk analysis is to estimate the extent of the impact that will be made if a given risk factor occurs. The good news is that many risks can be managed through hedging or other methods.
This is a general overview, but there are two different types of risk analysis that are worth discussing in more detail.
Types of Risk Analysis
The first is quantitative risk analysis. Quantitative risk analysis uses simulations and deterministic statistics to assign numerical values to risk. Input variables are fed into a simulator and an outcome is generated for each input range.
Once determined, the outcome for each risk factor is recorded in the form of a probability distribution of all possible outcomes. As you can imagine, these outcomes can be summarized and analyzed in various ways.
The primary two are through a graph showing means, medians, and the standard deviation and through scenario analyses.
The second type of risk analysis is qualitative risk analysis. As you can imagine, qualitative risk analysis focuses not on the numerical values of risk, but instead on the qualitative side of things.
A qualitative risk analysis will typically involve:
- written definitions of the various risk factors
- the potential impact of each risk factor
- a plan of action if the risk factor does occur
Common types of qualitative analyses include SWOT (Strength, Weaknesses, Opportunities, and Threats) analyses, matrices, cause and effect diagrams, and more.
A Few Things to Consider about Risk Analysis in Investments
Nothing is certain
Running some sort of risk analysis (and ideally both a qualitative and quantitative risk analysis) is highly recommended. However, we do want to acknowledge that no risk analysis will be able to perfectly predict the likelihood that a specific risk will occur.
Since risk is all about probability there is really no way to know for sure what your exact risk exposure is at a given time. The best a risk analysis can do is determine the distribution of potential impacts of various risk factors. Knowing these impacts can still be extremely helpful in making investment decisions.
Another thing to remember in thinking about risk analysis is that risk assessment models do not always — or usually — take into account extreme and unforeseen circumstances. Especially given the state of the economy over the last year, it is obvious that unforeseen circumstances can indeed occur. And unfortunately, they can be extremely disruptive to the marketplace.
Risk models will likely take unprecedented circumstances into account more after the events of the past year. But it is still wise to take even the most calculated risk analyses with a grain of salt.
So, Why Perform Risk Analysis in Investments?
We have now reviewed what risk analysis looks like. But why you need to do risk analysis in the first place?
It’s for weighing the risk factors of a given investment against its expected return. As mentioned previously, the comfortability that investors have with this balancing act varies greatly.
Next, we want to discuss high risk and low risk investing.
Do you know where you fall on the general spectrum of high to low-risk investment comfort level? Knowing this will be beneficial when assessing whether an index’s market risk factor fits into your comfort zone.
High-risk investments are those that have a high chance of underperforming, and thus of the investor losing capital. They are also generally investments that have a higher chance of yielding a high return. The degree to which an index is considered to have a high chance of underperforming can be subjective.
Some people more comfortable with risk might not think an index was likely to underperform unless it had a 10% chance or lower of earning its expected return. Meanwhile someone else might draw that line at 30%.
Low-risk investments are the converse. Hence, they have a high chance of delivering their expected returns but tend not to yield higher returns as some high-risk investments will. One of the biggest benefits of low-risk investments is that they ensure that none of the potential losses suffered by the investor will be devastating. This can make them a good option for risk-averse, long-term investors.
Do you have a long-term financial plan and are not inclined (or cannot afford to) to take on much risk? Then investing in low-risk indexes might make a lot of sense for you.
On the other hand, if you are looking for short-term results and high returns, and can afford to take on some risk, then high-risk indexes may be the right move for you.
Regardless of your financial plan and your comfort level with risk, it will benefit you to practice good risk management. Whether you have the time and expertise to be your own risk manager, or you would prefer to hire someone, it’s a good idea to have someone who knows how to go through risk analysis procedures when it comes to your investments.
Risk management gives you an idea of the potential losses you may be facing when investing in a given index. But it also quantifies the impact of the potential losses and — perhaps most importantly — can provide insight into ways you may be able to soften those losses preemptively.
Without risk, there is no reward
Risk management is also beneficial in that it gives the risk manager a better understanding of risk itself, and its role in the greater financial system. Understanding all the different forms of risk and how they relate to your investments are all incredibly important to helping investors better understand the risk factors associated with different investment opportunities.
- how and when to pursue risk-free rates
- what systematic risk looks like
- how a risk factor affects the return of the investment
How We Can Help
Here at Saddock Wealth, we’re very familiar with how to balance a client’s risk comfort level with investment opportunities.
We have been analyzing and managing risk for clients for many years. We are always sure to examine each client’s case individually, taking into account all of the factors that make their investment desires and risk tolerance unique.