Today’s article is the second of three discussing risk management and its use in managing a portfolio of investments, including precious metals. The first part highlighted the most important step: Identifying Risks. The purpose of the 3-part series is to provide you with the tools you may need to make wise investment decisions while avoiding unnecessary risks. After all, losing money is something we all want to avoid!
This series will not make specific investment recommendations and is not intended to persuade you to purchase any specific security or even precious metals. Rather, it is an educational piece designed to help you be a more effective investor, whatever vehicle you choose to use to meet your goals.
We are going to use hypothetical examples of investment risks for purposes of illustration in this article. In the last article, Part 3, I will perform a mock risk assessment based upon a set of risks I have chosen as an example to show you how the process works, and how simple it can really be. But first, let’s cover the remaining 4 steps in the risk management process before we proceed to the example in Part 3.
Step 2: Risk Measurement
This step is fairly obvious in its intent. We want to be able to measure potential risks on our savings portfolio so we can figure out if we want to take them. Measuring risk, however, can be a bit tricky in real life, so I tend to use best guesstimates for actual risk. There does exist literature and methods of calculating risk using fancy formulas, but those formulas rely on assumptions in the data used to calculate the result. So in reality, any measuring scheme has its own component of subjectivity involved.
If we are looking at stocks, for example, we might calculate potential financial risk by using common ratios like a Quick Ratio that describes how liquid a company may be based on current assets and liabilities. Or we may look at something more complex like a key performance indicator (KPI) used to measure relative industry performance.
An example KPI would be the growth rates of Netflix subscribers and whether the company can maintain current revenue growth, or whether it needs to focus on cost containment on a maturing subscriber base. Inherent in this analysis would be assumptions of Netflix’s potential market and an examination of current streaming subscriber trends. But any number we come up with is largely a guess. That’s ok because at least we are thinking of what could go wrong and how it could affect our investment. We have just measured our first risk!
Step 3: Risk Mitigation
This step can simply be described as any step taken by us to reduce the overall effect of a potential risk coming true. Once we have identified the risk (Step 1) and measured its potential impact on us (Step 2), then we can begin thinking of ways that we can reduce that risk that doesn’t cost us any more than the potential losses we stand to lose from the risk occurring.
In other words, risk mitigation can be looked at as a type of insurance against loss, but we don’t want to pay more in insurance premiums than we would if we just absorbed the loss in the first place. Let’s say that in the previous Netflix example, a loss of 1% in subscribers is expected to reduce top-line revenues by 3% while causing the stock value to fall 8-12%, for which our calculations are based upon previous instances for Netflix and other companies in the space (note these numbers are purely made up and used solely for purposes of illustration).
One risk mitigation we could take is reducing our position in Netflix to reduce the overall portfolio effects of the declining stock price. Another might be handcuffing our Netflix position with competitors in the space such as Disney+, whom we may have identified as a key competitor taking Netflix’s market share.
A rise in Disney may offset a fall in Netflix; but then again, it may not. By adding Disney to the portfolio, we have also just multiplied our number of potential risks and not reduced them. That can be a risky strategy in and of itself.
Both strategies may work; however, I will point out they are to reduce potential expected losses. Another longer-term view may be to avoid the risk in the first place. E.g., reducing a position in Netflix and moving into another asset class to reduce any long-term counterparty risks we see in companies involved in streaming.
At this point, the analysis becomes less about an individual investment position, and more about overall portfolio construction which is a subject we may cover in more depth in a future series. But for now, I think we get the point with regard to risk mitigation strategies.
Step 4: Risk Reporting and Monitoring
This step is very important. In my experience in corporate audit, it is also one that gets the least amount of attention. There is a saying that the ‘proof is in the pudding’. And if that is true, the risk reporting is the pudding itself. It tells us the truth about our financial investments and also about how we may individually view risk in our savings plans.
Quite often, reporting on risk (even to oneself using a dashboard as described in these articles) often takes the mystery out of it. It also tends to point out the mistakes in portfolio construction as they tend to stand out like a sore thumb.
In its most essential form, reporting and monitoring just mean putting it all down on paper (I choose an Excel spreadsheet, you may choose any format you like) and reviewing it periodically. Only then can we figure out the mistakes and where the ‘dead bodies’ are likely to be buried in our portfolios.
And only then can we then begin to make different decisions on risk, while taking positive steps in reducing our future losses. It may be ugly at times, but we must look at it! And in doing so, take steps to make it look much better going forward.
Step 5: Risk Governance
This is a fancy term that basically means putting management controls and rules in place to prevent a bad situation from occurring. In other words, as we manage our portfolios, we begin to construct our own personal rules for how we want to invest. And then, we ‘govern’ our risk of those investments using clear, consistent, and sound rules about what we invest in, how we invest in it, when we invest in it, and how and when we are going to liquidate that investment in the future.
That is basically risk governance, and it doesn’t need to be anything more than that really. You are your own boss in the investment world; these are rules that you are setting for yourself. And they will only be as effective as you are at following them!
Final Thoughts
There we are – we have completed our short education in risk management, as it applies to investing. That wasn’t really that hard, and in the process, we have developed a framework we can use to reduce our investment risk going forward regardless of what those investments may be at any particular time.
The final Part 3 of this series will be using an example I put together to show how this actually works in practice. This is for illustration purposes only, as we are not financial advisors. We are; however, educators and are happy to share with you our knowledge in the hopes it makes your own investment journey that much more positive and rewarding for you.
Rob Kientz is a precious metals industry expert with over twenty years of investment experience in bond, stock, real estate, commodities, Forex, and precious metals markets.
