Over the last couple of decades, institutional risk management has become an integral process at almost every large organization. Corporate risk managers concern themselves not only with financial risks, but with strategic and operational risks as well, evaluating possible future outcomes and their effect on their organizations.
The International Standards Organization has even attempted to standardize the process of organizational risk management, defining it as "the effect of uncertainty on objectives." It defines risk management as "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."
While these definitions look good on slide presentations at corporate risk management departments, they are probably a bit too abstract for the real world practice of managing assets for people. Still, they offer a framework to systematically evaluate and manage client risk. By explicitly defining what could happen, focusing in on the uncertainties and estimating costs, it's possible for investors to minimize and control their impact.
Most individuals, too, and their advisors are already managing risk in their investment process, even if they don't know it. Specifically, they try to curb the risk of suffering shortfalls when it comes time to cover future liabilities. The insurance they buy protects them against certain rare but costly events. But saving and investing is a type of insurance as well-essentially it's self-insuring against all other future liabilities, trying to prevent catastrophes in the future that you can't predict and whose magnitude is uncertain.
The goal of diversification is to manage liquidity and uncertainty in the asset class returns of a client's portfolio to cover future expenditures.
There are two ways we can tweak a portfolio to meet liabilities. First, after identifying and segregating uncertain future liabilities, we can match them to assets that are highly correlated with them. Second, we can imagine different scenarios that help us manage those risks better by ensuring sufficient liquidity.
The interesting thing about this approach is that, besides helping us prepare for catastrophe, it also gives us a higher overall portfolio return-because the risk profile is now better defined.
People can buy insurance in preparation for a number of horrible circumstances. They can insure against death, disability, health problems and medical emergencies, property loss and legal trouble. They can also partially insure things such as educational outlays (through prepaid tuition plans) and retirement income (through annuities). Of course, there are also catastrophic risks such as war, natural disasters and the government confiscation of property that can't be insured against-things that would hurt almost every asset class if they came to pass. But since there is no feasible way to manage these events short of building a survivalist compound stocked with food, weapons and gold bars, we will ignore them.
What we manage instead is the uncertainty in future asset values by putting them next to comparable future liabilities. We take investment risk and then divide it into further components of inflation risk, market risk, interest rate risk, credit risk, liquidity risk, etc. The historical effects of these risks on the returns of various asset classes are quantified as annual standard deviations, which are then used to compare the "riskiness" of expected returns.
Defining Risk With Investment Goals
Clients can manage their investment risk typically by building a diversified portfolio with an allocation and assets that seek the highest return for the client's risk appetite. Usually, the risk profile is defined as how tolerant the client is for losing money when he will need it to meet a few large defined expenditures: retirement, education costs, a house, etc. After an investor takes these liabilities into account, he invests the rest of the portfolio for preservation of capital on the one hand and growth on the other, with income sought somewhere in the middle. Defining other future liabilities and the risk associated with them allows an investor to lower his risk of a future asset shortfall.