In Chinese philosophy, yin and yang are principles whose interactions influence all destinies. Risk and return are the yin and yang of investing. They are two inseparable elements of the whole process. To look at an investment's rate of return without considering the degree of risk taken to achieve it is to consider only half the investment equation. This module focuses on the risk half of that equation-on the definition, identification, and measurement of portfolio risk-as well as on methods for controlling and managing it.

One of the problems in dealing with risk is that it lacks a single definition. It means different things to different people. Investment scholar Burton Malkiel calls it "a most slippery and elusive concept." Another problem is the fact that there are many types of risks, some of which reduce the effects of others. For investment professionals, these issues are complicated by the difficulty of measuring their clients' risk tolerances. As every experienced investment professional knows, some people can live comfortably with a degree of uncertainty that would practically paralyze others. However, despite various techniques to measure individual risk tolerance, a validated method has yet to be produced. Finally, the risk tolerance of an individual investor changes with age, income level, knowledge, and experience.

Fortunately, the ability to estimate the risk of a particular investment has improved through the use of quantitative techniques, primarily statistical analysis of underlying investment performance data. Statistical analysis helps identify the characteristics of an investment and evaluate its performance in relation to alternative investments. It also helps financial advisors understand relationships among different investments, an understanding that is essential to creating diversified portfolios. However, it is important to note that quantitative risk analysis is based on historical performance data. Because of the changing nature of companies, markets, and the economy, the volatility of an investment and its behavior in relation to other investments change over time. Therefore, past performance is not necessarily indicative of future performance. Portfolio management is essentially the management of risks, with portfolio return being a function of how well those risks are managed. This module will show you how risk can be managed and reduced through the use of various strategies.

Author: Jason G. Hovde, MBA, CFP®

Jason G. Hovde is the investments professor at the College for Financial Planning. Prior to joining the College, Jason had a financial planning/investment advisory practice and was a branch manager for one of the largest independent broker/dealers in the country. Additionally, he spent several years with another independent broker/dealer, first as a trader and options principal, and then as a member of the senior management team. Jason holds two bachelor’s degrees, one in accounting and the other in behavioral science from Metropolitan State University of Denver, as well as an MBA in finance and accounting from Regis University. You can contact Jason at jason.hovde@cffp.edu.

Complexity Level: Intermediate