Risks: why avoid them when they can be managed with awareness?

Risk arises when investors do not know what they are doing. So the key is not to ignore it, but to understand it, classify it and manage it systematically.

By Jörg Held, Head of Portfolio Management at Ethenea Independent Investors

Many investors see risk primarily as a threat. They therefore try to avoid uncertainty as much as possible, even though returns can only be generated when risks are taken in a conscious way. Warren Buffett neatly sums up this relationship: risk arises when investors do not know what they are doing. So the key is not to ignore it, but to understand it, classify it and manage it systematically.

Our risk management pursues three goals: protecting invested capital, limiting price fluctuations and finding a balance between return and risk. Especially in times of crisis, this approach helps contain significant losses and avoid rushed selling. How effectively a portfolio manages risks and turns them into returns is crucial. Risks appear at many levels: from global market swings to economic and political developments, and down to those linked to individual financial instruments. Our approach is above all to seize opportunities without being unnecessarily influenced by individual risks.

Why do only some risks generate a premium? In principle, risks can be divided into two categories: systematic risks and non-systematic risks. Systematic risks affect the entire market or whole asset classes. They cannot be eliminated through diversification. They must be taken on in order to achieve a return. Non-systematic risks, by contrast, are tied to individual securities or issuers. They can be significantly reduced through proper diversification without sacrificing return. For this reason, a premium is recognised in capital markets only for systematic risks.

Market risk is a central systematic risk. It appears when equity markets fall, when interest rates rise or when currencies and commodity prices fluctuate sharply. Such movements affect numerous assets at the same time. To assess risks more accurately, indicators such as volatility are used, which show how much values may vary. Credit risks, on the other hand, arise when states, companies or financial institutions are no longer able to meet their obligations. They may concern individual issuers, entire sectors or even countries. Ratings, default probabilities and market indicators such as credit spreads make it possible to assess these risks at an early stage.

Liquidity risks are often only taken into account during crisis periods. They arise when securities are difficult to sell or can only be sold at a lower price. In periods of stress, market liquidity can dry up. Thinly traded securities often suffer from poor liquidity even in calm periods. Indicators such as the bid-ask spread or trading volume make it possible to measure how quickly positions can be liquidated without having a significant impact on market price. An additional risk comes from insufficient diversification. If a portfolio is too heavily concentrated in specific securities, sectors or countries, even small events can cause considerable losses. These concentration risks can be limited through clear diversification rules and regular monitoring of the most significant positions.

Finally, the extra-market risks: currency risks, inflation and operational risks. Investing in foreign currencies entails additional risks. Exchange rates can either amplify or wipe out gains, regardless of how the value of the investment itself develops. Open positions in foreign currencies show the extent to which a portfolio depends on such fluctuations. On this basis, portfolio managers decide which currency risks they are willing to take and which they intend to hedge. Inflation acts quietly but persistently. When prices rise faster than the value of a portfolio, wealth loses substance in real terms. This risk concerns all investors. It cannot be avoided, only taken into account. Inflation forecasts and market-based indicators, such as break-even rates, provide guidance on this point.

Not all risks come from the markets. Inefficient processes, technical malfunctions or human error can cause just as much damage as regulatory intervention. These operational risks are difficult to quantify. They require clear processes, well-defined responsibilities and effective controls. In financial markets, risks can neither be avoided nor eliminated. They are the necessary condition for generating returns. What matters is whether they are taken on consciously, understood and managed continuously, or whether they affect the portfolio without being taken into account. This confirms the idea essentially expressed by Warren Buffett: risk does not stem from market fluctuations themselves, but from a lack of knowledge and insufficient systematic thinking. Those who manage risks in a structured way have no reason to fear them. On the contrary, they create the conditions needed for stable decisions, especially when markets are turbulent.