Investment firms and banks are in some of the most competitive industries in the world. While profitable returns on investment is what every investor strives for, at any moment stocks could also decline in value and lead to loss. Risk management is the process of identifying, assessing and controlling threats to an organization’s capital. It is one way firms attempt to maximize their risk adjusted return. A good risk management system will do more than just identify risk: it must be able to quantify it as well as predict its overall impact on the firm (Michael Stanleigh, financial professional and On the Money Volunteer).
In its most common manifestation, risk management utilizes advanced statistics to quantify how most events could play out as well as attempt to account for the likelihood and financial impact of an extreme event. Embedded in these algorithms are variables ranging from terrorist events to adverse weather. Using these equations, firms will calculate potential loss from the most outlandish to the most probable of events. Citadel, one of the most successful hedge funds across the globe, has an extensive and advanced risk management team that is integral to the success of the firm.
According to their website and speaking with firm risk management employees, Citadel utilizes the following three risk guidelines within their company:
1) Risk level: how much risk is Citadel willing to incur?
2) Stress exposure: how macroeconomic variables could impact the portfolio’s risk or return 3) Liquidity: the availability of willing buyers and sellers for any given asset.
After synthesizing the risk data, the firm will decide if the risk level falls within its acceptable risk parameters. How much risk a participant is willing to accept is dependant on their business model, investment philosophy, and a variety of other factors. For example, hedge funds are far more likely to incur more risk than say, a traditional long-only* fund. While risk management can be a complicated field, it plays a vital role in the health of an investment firm and it’s a career worth giving ample consideration.
*A long-only fund only takes long positions in a company whereas hedge funds can short, or bet against, the performance of a company (Dillon, Hoover, financial professional and On the Money volunteer).