Risk Management in Financial Planning

Risk is a big part of finance. Investments can make money — and sometimes a lot — but they can also make it disappear. Anything from real estate, stocks, or even bonds all carry uncertainty. For this reason, it’s important to take a calculated approach to mitigate or manage risk as much as possible.

But, for anyone who isn’t an expert, it’s not always easy to know just how risky an investment is. Finding that out typically takes both advanced knowledge and legwork. Financial advisors can offer guidance to help you know where to take your portfolio.

In this article, we’ll dive into risk management and explain how it works. Additionally, we’ll highlight the critical role financial advisors can play in helping you take chances while protecting your hard-earned assets.

Risk Management Basics

Risk management is a technique investors and financial professionals use to identify and minimize losses. It involves an in-depth analysis of investments using a variety of methods to understand how they’ll perform. This helps one decide whether specific opportunities are worth it.

Identification is the first ingredient of managing risk. It’s a way to understand all the problems that could potentially impact an investment. Market shifts, inflation, and operational issues, among others, are all causes for an asset to not reach expectations. Being keenly aware of these perils enables investors to make informed decisions about their portfolios or for advisory experts to help their clients do so.

However, awareness is just one piece of the puzzle. The next crucial step is analysis. Financial professionals wield a combination of methods to understand the dangers looming over an investment. They may use quantitative strategies, such as advanced tools or statistical models. Or some may take a more qualitative approach, like asking people with experience in a certain market how their investment performed. 

Numbers generally don’t lie, and, thus, are powerful predictors for how an asset will behave. But opinions or emotions of others can also fill in the contextual gaps that stats simply can’t. Therefore, using a blend of both tangible, data-driven models and subjective perspectives is the most effective and common way experts assess risk.

Types of Risks

Several types of risks can affect your investments in varying ways. Below is a list of the most common ones, along with some information about them:

• Market risk involves the way fluctuations in the stock market, interest rates, commodities, currency exchange rates, and more can affect your portfolio’s value and cause losses.
• Credit risk involves a person or company not paying back debts, such as loans or lines of credit, to a lender, resulting in losses.
• Liquidity risk is the danger that you won’t be able to sell an asset without losing a lot of money. It typically occurs if you need to quickly sell an investment but can’t find an ideal buyer, causing you to find one who’ll lowball you in price.
• Inflation is a consistent factor that can negatively affect an investment’s value over time. The danger is that your investments may not keep up with the rising costs of goods or services. This means that the initial amount of money you invested may not have the same purchasing power it once did.
• Operational risk is when businesses and organizations falter due to a range of factors and cause losses for stakeholders. Fraud, errors, technical issues, and more can lead to operational problems.
• Regulatory risk is when changes in laws, regulations, or other political factors negatively affect investments.
• Volatility risk involves the risk that a security’s price will fluctuate due to any number of circumstances, potentially leading to losses in investment value or decreased returns.
• Concentration risk, in most basic terms, is the danger of losses due to investing too heavily in specific asset classes, industries, or securities.
• Strategic risk refers to the potential of a business or entity to experience losses because of leadership decisions.
• Fraud risk is when an investment fails because of fraudulent activity by managers of a business or organization or external factors.

Risk Mitigation Strategies

As we briefly mentioned, investors and experts use various tactics to mitigate financial risk. Some of these rely on mathematics or data, while others use a more qualitative method. Here are some mitigation strategies you may see or discuss with an advisor:

Analyzing Standard Deviation

One of the most common ways to evaluate risk is using standard deviation. Specifically, this involves looking at how an investment’s returns can deviate from the average. In practice, professionals may analyze monthly returns over the last three years for a given investment to create a distribution of data. 

If the standard deviation is higher, results are less predictable and possibly more volatile. This leads to either high or painfully low returns. Conversely, low variance means that the data is closer to the average and, therefore, is more reliable. Understanding standard deviation offers a strong, holistic view of an investment’s volatility.

Position Sizing

Position sizing is a technique where you determine how much capital to place into an investment. We’ve all heard that it takes money to make money. While this can be true, putting more into an investment can also result in higher losses. By contrast, if you put less capital into a trade, you may lose some if something happens. But it’ll often be far less.

Diversification

Financial advisors often mention diversification as a primary way to safeguard your wealth. As any investor knows, some investments are safer, while others are more speculative or volatile. Diversifying your portfolio helps ensure that, even if some money goes to lucrative assets, you have other ones with steadier returns.

According to Fidelity, a diverse portfolio may contain a combination of real estate, domestic stocks, or bonds. For example, stock market investments may perform well, while a property may decline in value. On other occasions, the reverse could be true. In general, the idea is that your portfolio stays up, even if some assets are trending downward.

Diversification can also take place within asset classes. Investing in stocks from different industries is an example of this. This shields you from the scenario of investing all your money in, say, the tech space and losing a significant amount if the industry was down altogether. 

How Financial Advisors Help Manage Risk

When you sit down with your advisor, one of the main topics you’ll discuss with them is your risk tolerance. This can vary heavily from person to person. Here are some factors that could affect your preferred risk level:

• Risk capacity. How able are you to take a loss? People with fewer assets or more to lose may want a more stable portfolio, while others may be able to take bigger swings.
• Goals. What you want to accomplish informs your risk strategy. Are you planning for retirement, buying a home, paying off debt, or building your wealth?
• Time. How much time do you have until you need to realize your goals? Per U.S. Bank, distant goals, such as retirement, usually have more capacity to veer off track. This is because there’s more time for investment to bounce back from dips.
• Engagement. Do you prefer to be active with your investments or more hands-off? More engaged people might be able to keep up with riskier opportunities, while passive investors may benefit more from ones with steady, predictable returns.

Once you tell your professional about both your short- and long-term goals and risk tolerance, they’ll analyze and assess your portfolio to better understand how to align it with your desires. Then, expect to have discussions about the types of mitigation strategies, and how you’ll put them in place within your portfolio.

Over time, if you’ve established a long-term relationship, your advisor should consistently investigate all areas of your portfolio and communicate findings. You may even have to take steps to rebalance your portfolio, both through asset allocation and diversification, to cut down on uncertainties.

What Is a Financial Risk Manager?

While all trained professionals should implement strategies to manage unpredictability, some specialize in it. Common designations include Financial Risk Managers (FRMs), Certified Risk Managers (CRMs), and Certified Personal Risk Managers (CPRMs).

FRMs receive their title from the Global Association of Risk Professionals (GARP) and have extensive, focused training in various aspects of risk management. They often hold jobs at banks, investment firms, and advisory organizations. To receive the certification, FRMs must complete two multiple-choice exams and collect two years of work experience. 

Both CRMs and CPRMs earn their accreditation from The National Alliance for Insurance Education and Research. But the two titles have some differences. The CRM role generally centers around risk management for businesses and organizations, while CPRMs manage uncertainty and insurance for high-net-worth clients. Both certifications require candidates to complete five courses and take an exam.

Frequently Asked Questions

Which assets do risk-averse financial managers prefer?

Managers with the primary goal of mitigating risk prefer investments like certificates of deposit (CDs), government bonds, and high-yield savings accounts. These all share the trait of having predictable, stable returns.

Do I need to hire a financial advisor for risk management?

This can vary by situation and how complex your portfolio is. Hiring a professional is smart if you need help reaching your goals or planning your portfolio. They can give you insights and methods you can put into action to manage your portfolio’s risk.

If you’re unsure of how to find a financial professional, it’s a good idea to use a free matching tool. All you need to do is answer some quick questions and you’ll be matched with a vetted advisor who fits your needs.

Which is better, a CFA or FRM?

The best one to hire will depend on your needs. If you need high-level expertise in investment analysis and management, including risk assessment and minimization, a chartered financial analyst (CFA) is a good choice. But if your primary focus is on uncertainty and quantitative analysis, an FRM would be better, due to them specializing in the area. Ultimately, the decision depends on your specific requirements and the particular emphasis of the role you’re looking for.