What is Risk Management and how does it work?

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Risk management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions.

Essentially risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential losses in an investment, such as moral hazard and then takes the appropriate action given his investment objectives and risk tolerance.

Moral Hazard occurs when a party that has agreed to a transaction provides misleading information or changes their behavior because they believe that they wont have to face any consequences for their actions. In addition moral hazard may also mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Inadequate risk management can result in severe consequences for companies, individuals and the economy. Risk is inseparable from return in the investment world.

A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statistical measure of dispersion around a central tendency. 

Beta also known as market risk is a measure of volatility or systematic risk of an individual stock in comparison to the entire market

Alpha is a measure of excess return : money managers who employ active strategies to beat the market are subject to alpha risk.

A common definition of investment risk is “deviation from an expected outcome”. That deviation can be positive or negative and it relates to the idea of “ no pain, no gain “ to achieve higher returns in the long run you have to accept more short term risk in the shape of volatility.

How much volatility depends on your risk tolerance which is an expression of the capacity to assume volatility based on specific financial circumstances taking into account the psychological comfort with uncertainty and the possibility of incurring large short term losses.