Risk Management
Expert-defined terms from the Certificate in Private Wealth Management and Family Offices course at London School of Planning and Management. Free to read, free to share, paired with a globally recognised certification pathway.
Absolute Risk #
Absolute Risk
Concept #
The potential for loss or negative events to occur, regardless of any other factors or investments.
Explanation #
Absolute risk is the standalone likelihood of experiencing a negative event or loss. It is not influenced by other investments or factors, and is simply the inherent risk of a particular asset or decision. For example, the absolute risk of owning a particular stock may be high due to its volatility, even if the investor has a well-diversified portfolio.
Asset Allocation #
Asset Allocation
Concept #
The distribution of investments across various asset classes and types.
Explanation #
Asset allocation is the process of dividing investments among different asset classes, such as stocks, bonds, and cash, in order to manage risk and maximize returns. The goal is to create a balanced portfolio that aligns with the investor's goals and risk tolerance. For example, a conservative investor may allocate a larger percentage of their portfolio to bonds, while a more aggressive investor may allocate a larger percentage to stocks.
Beta #
Beta
Concept #
A measure of an investment's sensitivity to market movements.
Explanation #
Beta is a statistical measure that shows the relationship between an investment's returns and the returns of the overall market. A beta of 1 indicates that the investment moves in line with the market, while a beta greater than 1 indicates higher volatility and a beta less than 1 indicates lower volatility. For example, a stock with a beta of 1.5 would be expected to be 50% more volatile than the overall market.
Correlation #
Correlation
Concept #
The degree to which two investments move in relation to each other.
Explanation #
Correlation is a statistical measure that shows the relationship between the movements of two investments. A correlation of 1 indicates that the two investments move in the same direction, while a correlation of -1 indicates that they move in opposite directions. For example, a portfolio with investments that have low or negative correlations would be less risky than a portfolio with investments that have high positive correlations.
Derivative #
Derivative
Concept #
A financial instrument that derives its value from an underlying asset or group of assets.
Explanation #
Derivatives are financial instruments that can be used to hedge against risk or to speculate on the price movements of an underlying asset. Examples of derivatives include options, futures, and swaps. For example, a farmer may use a futures contract to lock in a price for their crops, thus reducing their risk of price fluctuations.
Diversification #
Diversification
Concept #
The spreading of investments across various asset classes and types to reduce risk.
Explanation #
Diversification is the process of spreading investments across various asset classes and types to reduce risk. The goal is to create a portfolio that is not reliant on the performance of any one investment, thus reducing the overall risk. For example, a diversified portfolio may include a mix of stocks, bonds, real estate, and commodities.
Downside Risk #
Downside Risk
Concept #
The potential for loss or negative events to occur.
Explanation #
Downside risk is the potential for loss or negative events to occur. It is a measure of the potential for an investment to decrease in value. For example, a stock with a high downside risk may be more likely to experience significant losses in a market downturn.
Expected Return #
Expected Return
Concept #
The anticipated rate of return on an investment.
Explanation #
Expected return is the anticipated rate of return on an investment, taking into account the potential risks and rewards. It is a forward-looking measure that is used to evaluate the potential performance of an investment. For example, a stock with a high expected return may be considered a good investment despite its higher risk.
Hedging #
Hedging
Concept #
The use of financial instruments to reduce or offset the risk of adverse price movements.
Explanation #
Hedging is the use of financial instruments, such as derivatives, to reduce or offset the risk of adverse price movements. The goal is to protect against potential losses by taking an opposite position in a related asset. For example, an airline may use hedging to protect against rising fuel costs by purchasing futures contracts for fuel at a set price.
Relative Risk #
Relative Risk
Concept #
The potential for loss or negative events to occur, in comparison to other investments or factors.
Explanation #
Relative risk is the potential for loss or negative events to occur, in comparison to other investments or factors. It is a measure of the risk of an investment relative to a benchmark or other investments. For example, a stock with a lower relative risk may be considered less risky than a similar stock with a higher relative risk.
Risk #
Risk
Concept #
The potential for loss or negative events to occur.
Explanation #
Risk is the potential for loss or negative events to occur. It is a measure of the likelihood and impact of potential adverse events. For example, an investment with a high risk may be more likely to experience significant losses, while an investment with a low risk may be more stable and less likely to experience losses.
Risk Management #
Risk Management
Concept #
The process of identifying, assessing, and controlling risks to achieve specific objectives.
Explanation #
Risk management is the process of identifying, assessing, and controlling risks to achieve specific objectives. It involves the use of various strategies, such as asset allocation, diversification, hedging, and risk retention, to manage risk and maximize returns. For example, a well-diversified portfolio is a common risk management strategy used to reduce the overall risk of a portfolio.
Standard Deviation #
Standard Deviation
Concept #
A measure of the volatility or dispersion of returns.
Explanation #
Standard deviation is a statistical measure that shows the volatility or dispersion of returns. It is a measure of the spread of returns around the average return. For example, a stock with a high standard deviation would be considered more volatile than a stock with a low standard deviation.
Volatility #
Volatility
Concept #
The degree of fluctuation in the value of an investment.
Explanation #
Volatility is the degree of fluctuation in the value of an investment. It is a measure of the variation in returns over time. For example, a stock with high volatility would be expected to have more dramatic price swings than a stock with low volatility.
Alpha #
Alpha
Concept #
A measure of an investment's excess return relative to a benchmark.
Explanation #
Alpha is a measure of an investment's excess return relative to a benchmark. It is a measure of the value added by the investment manager, beyond what would be expected based on the investment's beta. For example, a stock with an alpha of 2 would be expected to outperform a benchmark by 2% over a given period.
Arbitrage #
Arbitrage
Concept #
The simultaneous purchase and sale of an asset to profit from a price difference.
Explanation #
Arbitrage is the simultaneous purchase and sale of an asset to profit from a price difference. It is a risk-free trade that takes advantage of mispricings in the market. For example, an arbitrage opportunity may exist if the price of a stock is lower in one market than in another.
Capital Asset Pricing Model (CAPM) #
Capital Asset Pricing Model (CAPM)
Concept #
A model that estimates the expected return on an investment based on its beta.
Explanation #
The Capital Asset Pricing Model (CAPM)