Investment Risk Management Defining the Right Framework

Not all risks can be precisely defined by mathematical distributions, with some even defying measurement. Frank Knight famously distinguished between measurable and unmeasurable risks in his dissertation titled ‘Risk, Uncertainty and Profit’, warranting a clearer distinction between the two. Given the variety and breadth of risks inherent in the capital markets, oversimplifying risk to support measurement may be perilous. While managing investment portfolios, not only do the managers have to account for the intended risks, but also concealed risks which can have a significant impact on returns. This in turn makes risk management the very foundation of a well-run investment process and not just a component of the investment strategy.

The global financial crisis brought risk management to the forefront and highlighted how the absence of an all encompassing risk framework may prove disastrous for asset managers. The market’s behaviour in the crisis showed that existing risk management practices failed when they were needed the most, especially as the risk extended to previously uncorrelated asset classes. Although such Black Swan events  may be impossible to predict ex-ante, implementing a comprehensive investment risk framework helps asset managers manage risk for normal times and also be mindful of and aim to be prepared for such extreme events. So what does sound risk management mean for asset managers?

The principles of an effective investment risk management framework are based on the investment objectives and expectations around risk, quantification of those risks, process for managing those risks and oversight on the entire process.

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