Active Risk Management

What is active risk management?

Active Risk Management is the process of actively attempting to direct and control the possibility of loss in an investment portfolio. There are many ways to actively manage risk, including setting predetermined exits (stop loss), using derivates with a limited downside, or hedging.

Risk management is defined by Investopedia as:

” the process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance.”

The problem with that definition is it doesn’t draw a clear distinction between risk “measurement” and risk “management”. To measure is to quantify a dimension or capacity or amount as ascertained by comparison with a standard. To measure risk is to determine “how much” risk it is. We must first identify the risk: “what is a risk”. But to manage risk is an activity. To manage is to direct or control. Management is a dynamic activity we do. There is nothing passive about managing risk. I often call it “active risk management” because many people in the investment industry claim they “manage risk”, but they don’t actively direct and control their exposure to loss (the risk).

What is Risk?

I believe when we are speaking of money, a risk is the exposure to the possibility of loss. If we incur a loss, that isn’t a risk, that’s an actual loss. Some people believe that uncertainty is a risk, but we always have uncertainty. We can’t be certain about an outcome. Uncertainty is something we live with every day and in all things, so we may as well embrace it and enjoy not knowing the outcome of things in advance. So, a risk is the exposure to a chance or possibility of loss. It’s the exposure that is the risk, the chance or possibility is always there. So, your risk of loss is your choice. We decide it in advance.

How do you define Active Risk Management?

Active Investment Risk Management uses tactics and systems to actively make decisions to decrease or increase exposure to the potential for loss.

The investment management industry does not draw accurate distinctions between different activities, so these definitions are my own. When we speak of “active investment risk management” or “active risk management”, we necessarily mean a tactic of buying and selling securities (stocks, bonds, commodities) for the purpose of reducing risk (defined as exposure to the possibility of loss).

Active Risk Management does not mean risk measurement or asset allocation. I define risk as exposure to the chance of a loss. If we have no possibility of a loss, we have no exposure and no risk. Risk is a function of exposure. If we have no exposure to the possibility of a loss we have no risk. Therefore, to accomplish active risk management or active risk reduction, we’d have to sell to reduce our exposure.

Investors could incorrectly confuse these tactics with an active asset allocation function, but it does not fit in the conventional definition of asset allocation which is more fixed. Therefore, asset allocation in its conventional form is not active risk management. Asset allocation investors instead prepare a fixed asset allocation between cash, bonds, stocks, commodities, real estate, etc.  and call it “asset allocation policy or strategic asset allocation”. Asset allocation investors may try to use similar terminology to describe their methods of asset allocation which are actually not at all a part of active risk management as we define it. Deciding on a policy for spreading capital across different assets and markets is not active risk management. The only risk that asset allocation strategies manage is selection risk: the possibility of an individual position losing value. If you don’t have a large exposure to that stock, you may not have a large risk exposure but you’ll also have little exposure to a capital gain. Active Risk Management tactics may increase and decrease the exposure to gain and loss by buying and selling. Asset allocation investors are more concerned with eliminating the risk of an individual position by diversifying it away. Asset allocation investors diversify away from the “alpha” which is the excess return that is possible from a large winner and they seek only the market-driven risk and reward (the beta). Asset allocation investors are therefore fully exposed to the largest risk: market risk. During bear markets and the financial crisis that has occurred many times in the past, all markets tend to fall together at some point. When markets like stocks, bonds, real estate, all fall together diversification and asset allocation methods are of no use in controlling downside losses. The only way to actively control downside losses is to change the exposure. Active risk management systems that control risk are necessary before large losses occur.

See also Active Volatility Management 

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