There are a myriad of reasons for investment risk management. Each investment venture is potentially risky. It can give a low or negative return, for instance; earn below expectations and become a lost opportunity; or end up in a downward market and become a permanent loss. In the wake of market events and an increasingly uncertain environment, like the Asian Financial Crisis in 1997, the Global Financial Crisis in 2008, and more recently, the worldwide Covid-19 pandemic, even the smallest incident can be compounded, and have far-reaching consequences that impact negatively on businesses and their investment decisions.
Investment risk is a major challenge in this age of uncertainty. There’s market risk: the risk of a decline in the value of an investment due to unfavourable movement in price. The main types of market risk are equity, interest rate and currency risk. Another type of investment risk is liquidity risk, the risk of not being able to dispose of an investment at a fair price, or at a much lower price, or not being able to sell. There’s also concentration risk, when investments may be too concentrated in one particular industry or geographical area. Credit risk is also an investment risk, as are reinvestment, inflation and horizon risks.
Despite the presence of risk at every turn, taking risk is an integral part of business. Every business should therefore have in place a well-articulated procedure for the timely assessment and evaluation of investment risk and performance, together with adequate accountability, clear lines of authority and separation of duties. Investment risk management usually starts with a comprehensive investment policy that covers the organisation’s investment objectives; its performance measurement, monitoring and benchmarking; control procedures, risk tolerances or risk monitoring procedures; and the reporting format and frequency.
There may also be instances where investments in certain assets require special risk controls, or the organisation’s investment may be perceived as a contradiction of its declared position on environmental conservation, for example. More recently, the social risk of investments has also come under scrutiny; not considering this when making investments may be detrimental to the organisation’s reputation, giving rise to reputational risk. But market analysts have pointed out an advantage: investment risk management information can be applied to broader ERM efforts and help in decision-making.
This information may be useful from a mainstream perspective for investors who are considering funding social purposes or not-for-profit organisations. However, regardless of the reasons for investing, investment risk management starts with understanding the investment planning and management processes. Typically, the investment management process involves determining investor needs, assessing risk tolerance, reviewing asset allocation classes, implementing strategic plans, rebalancing and monitoring the portfolio, and comprehensive reporting. The investment planning process can be laid out in four main steps.
These cover determining the investment objectives; developing investment policy statements; measuring results; and reviewing investment objectives. In business, managing risk is more important than making a profit, particularly where growth and sustainability are concerned. Proper risk management will ultimately lead to profitable investing in the long term. When setting investment objectives, a number of factors need to be considered, including time horizon, risk tolerance, liquidity issues, income needs, income taxation, estate taxation, legacy concerns and charitable interests.
Carefully considering these factors will help the organisation develop an appropriate investment strategy and aid in the identification of an appropriate investment vehicle. There should be an ongoing portfolio review running in parallel, to track any changes in objectives, resources or needs, and if the investment is performing as per expectations. If it is not, modifications can be made as required. When it comes to the investment policy statement, the areas that should be covered include objectives, strategy, asset allocation, benchmarking, performance measurement, risk limits and constraints, monitoring and reporting.
To be successful, an investment process needs a risk management structure that addresses multiple aspects of risk. A best practice framework for this should cover risk measurement and risk monitoring, besides investment risk management. Risk measurement means using the right tools to accurately quantify risk from various perspectives while risk monitoring tracks output from the tools and red-flag anomalies in a timely manner. The information derived from measuring and monitoring can be used to align the investment portfolio with expectations and risk tolerance. Also, some investments are just riskier than others.
Challenges abound; even with the best strategies, and applying best practices, things can still go wrong. Organisations may use inappropriate risk metrics. For example, risk-measuring models like Value at Risk (VaR) and volatility will not include all positions and all risks. Additionally, they are backward-looking and do not properly represent extreme events; they do not tell a worst-case scenario. Mismeasurement may also occur when assessing the probability or size of losses, or known risks may not be taken into account. Besides this, risks may not be communicated to the board and management, leading to an overly optimistic perception of the real situation.
The organisation may also be unable to capture all changes to risks and the environment fast or clearly enough, which could lead to wrong assessments that will affect decision-making. Risk professionals should note that the first rule of investment risk management is to embed risk management in all their actions. They should also consider positive risks and opportunities, as these may make faster (and better) returns on investment. Ownership issues, i.e., who is responsible for which risk, should be clarified. The risk owner is responsible for optimising the risk; the challenge is to decrease threats and increase opportunities.
Be aware that some risks have a higher impact than others. Identify which can cause the biggest losses or gains, and prioritise accordingly. This will require risk analysis; consider what the effects of the risk will be, and what is likely to make it happen. Remember that implementing a risk response is what adds value to the investment. There are three options when it comes to this: risk avoidance, risk minimisation or risk acceptance. Successful investment risk management requires a risk management structure that addresses multiple aspects of risk; good risk management provides a clear line of sight of risks so that the board and management can apply the necessary measures.
