Systematic Risk Management

Systematic Risk Management Defined

What does Systematic Risk Management mean?

To define systematic risk management, let’s first define each word.

What does Systematic mean?

Systematic in general means ‘done according to a plan or system‘, We can also speak of systematic learning (i.e. following a system or set of principles) and a systematic search (i.e. one done methodically); the second is only a slight extension in the meaning of the first.

In portfolio management, we define ‘systematic’ as: Having clearly defined rules that can be defined mathematically (quantitatively, as an equation) and tested empirically (derived from observation or experiment: empirical results that supported the hypothesis. Verifiable or provable by means of observation or experiment).

‘Systematic’, then, can refer to a systematic research process of testing in search of answers or systematic trading.

What is Risk?

We cannot eliminate investment risk. All investments carry some degree of risk. Stocks, bonds, funds, etc. can lose value, even all their value, if markets decline. Even conservative, insured investments, such as certificates of deposit (CDs) issued by a bank or credit union, or fixed annuities, come with inflation risk. They may not earn enough over time to keep pace with the increasing cost of living.

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 actual loss. Some people believe that uncertainty is the risk . But, we always have uncertainty. We can’t be certain about an outcome. Uncertainly 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, the risk is the exposure to 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.

What is Risk Management?

Risk Management, as I define it, uses tactics and systems to make decisions actively 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 “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).

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 the conventional definition of asset allocation which is more fixed. Therefore, asset allocation in its traditional form is not 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 not at all a part of risk management as we define it. Deciding on a policy for spreading capital across different assets and markets is not risk management. The only risk that asset allocation strategies manage is selection risk: the possibility of an individual position losing value. During bear markets and financial crisis that have 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.

Systematic Risk Management is applying a clearly defined set of rules to limit, direct, and control the possibility of loss.

To learn more and see how we do it, visit Shell Capital Managment, LLC.