2 Types of Risk Pros Use One, Novices the Other

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Types of Risks – Risk Exposures – Part 2

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An Introduction to Risk Management

Types of Risks – Risk Exposures Part 2

In this section, you will learn to differentiate between diversifiable and nondiversifiable risks.
You will also learn about enterprise risk management.

Diversifiable and Nondiversifiable Risks

Another important dichotomy risk professionals use is between diversifiable and nondiversifiable risks.

Diversifiable risks are those that can have their adverse consequences mitigated simply by having a well-diversified portfolio of risk exposures.

Having some factories located in nonearthquake areas or hotels placed in numerous locations in the United States diversifies the risk. If one property is damaged, the others are not subject to the same geographical phenomenon causing the risks. of risk exposures.

Diversifiable and Nondiversifiable Risks (Continued)

A large number of relatively homogeneous independent exposure units pooled together in a portfolio can make the average, or per exposure, unit loss much more predictable, and since these exposure units are independent of each other, the per-unit consequences of the risk can then be significantly reduced, sometimes to the point of being ignorable.

Diversification is the core of the modern portfolio theory in finance and in insurance. Risks, which are idiosyncratic (with particular characteristics that are not shared by all) in nature, are often viewed as being amenable to having their financial consequences reduced or eliminated by holding a well-diversified portfolio.

Systemic risks that are shared by all, on the other hand, such as global warming, or movements of the entire economy such as that precipitated by the credit crisis of fall 2008, are considered nondiversifiable. Every asset or exposure in the portfolio is affected. The negative effect does not go away by having more elements in the portfolio. The field of risk management deals with both diversifiable and nondiversifiable risks.

As the events of September 2008 have shown, contrary to some interpretations of financial theory, the idiosyncratic risks of some banks could not always be diversified away. These risks have shown they have the ability to come back to bite (and poison) the entire enterprise and others associated with them.

Examples of Diversifiable Risk- Idiosyncratic Risk:

Click to see examples of Diversifiable/ Idiosyncratic Risks:

Examples of Nondiversifiable Risk- Systematic Risk:

Click to see examples of Nondiversifiable/ Systematic Risks:

Examples of Diversifiable Risk- Idiosyncratic Risk:

Reputational risk
Brand risk
Credit risk (at the individual enterprise level)
Product risk
Legal risk
Physical damage risk (at the individual enterprise level) such as fire, flood weather damage
Liability risk (products liability, premise liability, employment practice liability)
Innovational or technical obsolesce risk
Operational risk
Strategic risk
Longevity risk at the individual level
Morality and morbidity risk at the individual level

Examples of Nondiversifiable Risk- Systematic Risk:

Market risk
Regulatory risk
Environmental risk
Political risk
Inflation and recession risk
Accounting risk
Longevity risk at the societal level
Morality and morbidity risk at the societal and global level (pandemics, social security program exposure, nationalize health care systems, etc.)

The previously mentioned samples provide examples of risk exposures by the categories of diversifiable and nondiversifiable risk exposures.

Many of them are self explanatory, but the most important distinction is whether the risk is unique or idiosyncratic to a firm or not.

The reputation of a firm is unique to the firm. Destroying one’s reputation is not a systemic risk in the economy or the market-place.

On the other hand, market risk, such as devaluation of the dollar is systemic risk for all firms in the export or import businesses.

As discussed above, the opportunities in the risks and the fear of losses encompass the holistic risk or the enterprise risk of an entity.

The following is an example of the enterprise risks of life insurers in a map
in Figure 1.6 “Life Insurers’ Enterprise Risks”. [2]

Since enterprise risk management is a key current concept today, the enterprise risk map of life insurers is offered here as an example.

Operational risks include public relations risks, environmental risks, and several others not detailed in the map in Figure 1.4 “Risk Balls”.

Because operational risks are so important, they usually include a long list of risks from employment risks to the operations of hardware and software for information systems.

Download and study the following case study PDFs from the module resource section for this course.

Case Study 1: The Risk of E-exposures

This case study discusses the risks we face when we conduct our business on the Internet.

Case Study 2: Risks in the New Millennium

This case study discusses that variety of risks that we have encountered since the start of the new millennium.

You should be able to differentiate between diversifiable and nondiversifiable risks.
You should also understand the general concept of enterprise-wide risk.

[2] Etti G. Baranoff and Thomas W. Sager, “Integrated Risk Management in Life Insurance Companies,” an award winning paper, International Insurance Society Seminar, Chicago, July 2006 and in Special Edition of the Geneva Papers on Risk and Insurance.

[3] Reprinted with permission from the author; Etti G. Baranoff, “Risk Management and Insurance During the Decade of September 11,” in The Day that Changed Everything? An Interdisciplinary Series of Edited Volumes on the Impact of 9/11, vol. 2.

[4] com_content&task=view&id=932&Itemid=587 , and com_content&task=view&id=930&Itemid=585 .

[5] Laurent Condamin, Jean-Paul Louisot, and Patrick Maim, “Risk Quantification: Management, Diagnosis and Hedging” (Chichester, UK: John Wiley & Sons Ltd., 2006).

The 5 Most Effective Risk Management Techniques that the Pros Use

Risk management. It’s a topic that comes up often in trading blogs, books, and courses. But is it really practical? I mean, if you put a trade on, then you know the market is going to go your way, right? Stops are for buses!

Risk management must be part of your core trading strategy. Protecting the money you made is the way to make consistent profit, and ensure you have a long, successful trading career.

Like I’ve said before, if you make 1,000% in 2020, then lose 80% in January 2020, you’re not going to be a trader for very long.

Trading without risk management is like skydiving without a second parachute. What happens if the first one doesn’t open?

Using indicators to make profit will only get you so far if you’re not protecting your positions.

I’m bringing the best risk management strategies to you straight from the horses mouth. Read on to find out the most effective risk management strategies that the pros use!

1) Consider Your Portfolio as a Whole to Ensure Long-Term Survival

Alexander Lowry (@AlexanderSLowry) is a professor of finance at Gordon College, and also the Director for the school’s Master of Science in Financial Analysis program. He recommends that you view your portfolio as a whole, not just a series of individual bets.

Here’s his advice:

“There’s a secret of professional investors: on the whole, individual stock selection doesn’t really matter. What really matters, over the long term, is asset-allocation decisions. It’s not what stocks you buy. It’s when you buy stocks versus when you buy bonds, gold, cash, real estate, etc. that matters.

Several academic studies demonstrate why portfolio allocation (how much of which type of assets you own) is far more important in determining your results than simply which stocks or bonds you buy. The takeaway from these studies is that asset allocation is far more important to your total portfolio return than stock picking. That’s why most professional investors (like the top hedge-fund managers) allow analysts to do the stock picking, while they focus almost exclusively on the core allocation decisions.

On the other hand, most individual investors don’t spend any time or effort on managing asset allocation. They’re typically fully invested in stocks all the time. Most individual investors don’t even know how to buy bonds (which is a critical component of asset allocation), and they do a terrible job at position sizing, another critical component.

Think about this in terms of risk management by not putting all your eggs in one basket. Perhaps someone today thinks bitcoin will be a home run and they’ve got 50% of their assets invested in it. That’s far too leveraged of a bet. Especially for an asset as volatile as bitcoin.

Asset allocation is the component of your wealth plan that deals with the amount of money you have in various assets. How much of your wealth is in cash? Stocks? Precious metals? Real estate? This all goes under the umbrella of asset allocation. The number one goal with asset allocation is to avoid taking too much risk in just one asset class… because when one asset class “zigs,” others will “zag.” In this way, effective asset allocation allows you to sidestep financial disaster.”

Diversification is the real benefit here. You’re no longer reliant on a single asset class performing well, and will be protected from big swings in a single asset.

2) Use Stops to Limit Your Losses

Nate Masterson has been a freelance Financial Consultant since 2020, and is currently the Marketing Manager for Maple Holistics. He advises the use of stop losses to limit downside risk, saying:

“One of the easiest and most effective ways of protecting yourself against the risks of a volatile market/trade is by using stop losses. When you know how to utilize them correctly based on the nature of the stock, commodity or index that you’re trading with, you can protect yourself quite effectively against losses or inefficient trading, i.e. trades that lose money, rather than earn profit.

While the principle of a stop loss is pretty straight-forward, the art comes in knowing how to treat each trade individually. This is done most effectively with experience in the marketplace, and having a general and specific understanding of the factors that affect each trade independently — whether that’s innovation in the relevant sector/industry, global affairs and political issues, or even things as arbitrary as the weather. Taking as much into account before you set a stop loss, based on your prior experience with the stock/commodity/index, will allow you to make a good assumption and ultimately protect your trade.

As Masterson says, the idea of a stop loss is to close your position if the market goes too far against you, before you lose too much money and wipe out your account. Here’s how to go about setting a stop loss:

The first step is to set a threshold for your trade. This is essentially the maximum amount that you’re willing to lose on the trade before selling and can usually be expressed as a percentage of the initial purchase price. However, deciding on the triggers for that threshold are where experience really comes in handy as certain stop losses work better when considering a high-low average over a certain time period, while others should simply act as automated ‘blockers’ that allow you to protect your investment up to a reasonable point.

My advice would be to always consider the previous trends in the stock/commodity/index over the past week and then review whatever news you can find related to the subject online before deciding how to place your stop loss and at what amount you’d like to set it or based a certain movement pattern.

Once you have as much information as you can gather on the trade before making it, you’ll be better suited to protect your investment by creating a stop loss that is both accurate and realistic.”

Stop losses should be at the core of your risk management strategy. Whether they’re actual stop orders with your broker, or stop losses set in your trading system, they should be there.

3) Take Advantage of Trailing Stops to Protect Your Profit

In addition to static stop losses, you can use trailing stops. For a long position, this is essentially a stop loss that follows the price of the asset as it moves up, but stays put if the asset price starts to go the other way. And vice versa for a short position. A trailing stop allows you to lock-in profit as you make it, by protecting you against significant moves against your position.

Marc Lichtenfeld (@stocksnboxing) is the Chief Income Strategist of the Oxford Club, the Sr. Editor of the Oxford Income Letter and the author of two Amazon #1 Best Sellers: Get Rich with Dividendsand You Don’t Have to Drive an Uber in Retirement. He says:

“At the Oxford Club, we use a 25% trailing stop and recommend investors allocate 4% or less of their trading capital to any single position. That way, if the stock is down 25%, the most the investor can lose is 1% of their portfolio, which is a sum that’s easy to recover from.”

Additionally, Lichtenfeld recommends the stop be lifted every time the stock hits a new high, in order to protect profits and ensure investors aren’t riding a loser all the way down to the basement. And that stops should be set on a closing basis rather than intraday to avoid being shaken out of stocks that drop suddenly only to quickly rebound such as in a flash crash.

“When a stock closes at or below your stop, investors can have more confidence that the move lower is for real, rather than market noise.”

4) Size Your Positions Correctly to Optimize Your Risk Level

Position sizing is a critical component of your risk management strategy. By using it correctly you can avoid large drawdowns in your trading capital, while maintaining profit.

Alexander Lowry states that proper position sizing is, “One of the most important decisions you’ll make as an investor, and it is even more critical during volatile markets like today.”

Carter Johnson runs UBL Holdings and invests primarily in private companies, he suggests using the Kelly Criterion model to size your positions. The basic premise is that the size of your position should be proportional to the expected outcome. Expected outcome is the probability of making a gain multiplied by the gain amount, plus the probability of making a loss multiplied by the loss amount.

“The Kelly Criterion Model has been used by some of the greatest investors and traders of all time. It allows one to figure out with given probabilities how much capital can be wagered on a specific outcome. You can also incorporate a way to manage against overall portfolio draw down when position sizing.”

We’re not going to go into detail about the Kelly Criterion model here, but if you want to find out more, I highly recommend reading Johnson’s excellent article.

5) Utilize Covered Calls to Minimize Downside Risk

Mike Scanlin (@borntosell)has been trading covered calls for 37 years, and has been CEO of the covered call web site, Born To Sell, since 2009. He suggests using covered calls to reduce the risk of long positions.

“A simple way to reduce the risk of holding stocks and ETFs, while increasing cash flow at the same time, is to sell call options against your shares each week or month. It’s called “writing a covered call” (where you own the underlying stock but sell (short) call options against those shares). The negative is you put a cap on your upside, but in return you gain weekly or monthly income to protect part of any downside move. If you do this consistently over many months or years you will achieve a higher risk-adjusted performance than buy-and-hold (i.e. higher return with lower standard deviation — see academic studies proving this). Many pros and amateurs do this today. Schwab has said that 84% of their accounts that trade options use covered calls. It’s a simple and effective risk reducer / income generator.”

While Scanlin talks exclusively about stocks, this method can be used for any asset, including cryptocurrencies! The problem we have in the crypto world is that there’s only 1 exchange that deals in options, Deribit. This makes dealing with options more difficult, but at least the option (no pun intended!) is there.

There you go! Now you have insight directly from the pros. You might have heard of many of these techniques before from finance classes or other literature, and dismissed them as pure theory. But they’re actually used in practice, and you can use them too!

The major components of your risk management strategy should be:

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  • Stop losses
  • Correct position sizing
  • Asset allocation

The covered call strategy is more advanced, and definitely difficult to utilize in the cryptocurrency world, but the option is there for those of you who want to experiment with more advanced strategies.

“The elements of good trading are: 1) cutting losses, 2) cutting losses, and 3) cutting losses. If you can follow these three rules, you may have a chance.” — Ed Seykota

As the Market Wizard himself says, PROTECT YOUR CAPITAL.

The strategies listed above are all focused on protecting your portfolio against loss, they won’t necessarily help you to improve your profit on a per trade basis, but they will help your monthly and yearly total profit increase because the size of your losers will decrease.

If you use any other risk management strategies, let me know in the comments below!

DISCLAIMER:The information in this article is provided for educational purposes only. I am not a financial advisor and this article does not contain financial advice. Make your own decisions about risk, or consultant a professional financial advisor.

1. Risk Management: Identifying Risks

Термины в модуле (35)

a. Discuss features of the risk management process, risk governance, risk reduction, and an enterprise risk management system

This definition highlights that risk management should be a PROCESS, NOT JUST AN ACTIVITY

1. Defines its risk tolerance, which is the level of risk it is willing and able to bear.

2. Identifies the risks, drawing on all sources of information

3. Measure these risks using information or data related to all of its identified exposures

*Risk measurement more often than not it involves expertise in the practice of modeling and sometimes requires complex analysis

The execution of risk management transactions is itself a distinct process; for portfolios, this step consists of trade identification, pricing, and execution

2. Then we select the appropriate pricing model and enter our desired inputs to derive our most accurate estimate of the instrument’s model value.

3. Look to the marketplace for an indication of where we can actually execute the transaction.

If the execution price is “attractive” (i.e., the market will buy the instrument from us at a price at or above, or sell it to us at a price at or below, the value indicated by our model), it fits our criteria for acceptance;

If not, we should seek an alternative transaction.

In areas in which they do have an edge, they tend to hedge only tactically.

They hedge when they think they have sufficient information to suggest that a lower risk position is appropriate.

They manage risk, increasing it when they perceive a competitive advantage and decreasing it when they perceive a competitive disadvantage (they EFFICIENTLY ALLOCATE RISK)

RM involves far more than RISK REDUCTION or HEDGING (one particular risk-reduction method)

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