By Jörg Held, Head of Portfolio Management at ETHENEA Independent Investors
Many investors primarily view risk as a threat. As a result, they try to avoid uncertainty as much as possible, even though returns can only be generated when risks are consciously assumed. Warren Buffett aptly summarizes this relationship: risk arises when investors do not know what they are doing. It is therefore not essential to ignore risk, but rather to understand it, classify it, and manage it systematically.
Our risk management pursues three objectives: protecting invested capital, limiting value fluctuations, and finding a balance between return and risk. Especially in times of crisis, this approach helps to limit significant losses and avoid hasty sell-offs. How effectively a portfolio manages risks and transforms them into returns is crucial.
Risks arise at many levels. They range from global market fluctuations and economic and political developments to those associated with individual assets. Our approach focuses above all on capturing opportunities without allowing individual risks to exert unnecessary influence.
Why do only certain risks generate a premium?
In principle, risks can be divided into two categories: systematic risks and non-systematic risks. Systematic risks affect entire markets or asset classes. They cannot be eliminated through diversification. To earn a return, they must be accepted. Non-systematic risks are linked to individual securities or issuers. They can be significantly reduced through sufficient diversification without sacrificing returns. For this reason, capital markets reward only systematic risks with a risk premium.
Market risk is a central systematic risk.
Market risk is a central systematic risk. It materializes when equity markets decline, interest rates rise, or currencies and commodity prices fluctuate sharply. Such movements affect many assets simultaneously. Indicators such as volatility are used to better assess these risks, as they show the extent to which values may fluctuate.
Credit risks arise when governments, companies, or financial institutions are no longer able to meet their obligations. They may affect individual issuers, entire sectors, or whole countries. Ratings, default probabilities, and market-based indicators such as credit spreads allow these risks to be assessed at an early stage.
Liquidity risks are often only considered during periods of crisis. They occur when securities are difficult to sell or can only be sold at a discounted price. In times of stress, market liquidity can dry up. Thinly traded securities often lack liquidity even in calm periods. Indicators such as bid-ask spreads or trading volumes help measure how quickly positions can be liquidated without significantly influencing market prices.
Another risk results from insufficient diversification. If a portfolio is overly concentrated in specific securities, sectors, or countries, even minor events can lead to substantial losses. These concentration risks can be mitigated through clear diversification rules and regular monitoring of the largest positions.
Risks beyond markets: currency, inflation, and operational risks.
Investing in foreign currencies entails additional risks. Exchange rates can amplify or offset gains, regardless of the performance of the underlying investment itself. Open foreign currency positions show the extent to which a portfolio is exposed to such fluctuations. Based on this, portfolio managers decide which currency risks they are willing to assume and which they prefer to hedge.
Inflation acts quietly but persistently. When prices rise faster than the value of a portfolio, wealth loses real purchasing power. This risk affects all investors. It cannot be avoided, only taken into account. Inflation forecasts and market-based indicators such as breakeven rates provide guidance in this regard.
Not all risks originate in the markets. Deficient processes, technical failures, or human error can cause as much damage as regulatory intervention. These operational risks are difficult to quantify. They require clear processes, well-defined responsibilities, and effective controls.
Risk management as a stabilizing framework
In financial markets, risks can neither be avoided nor eliminated. They are a prerequisite for generating returns. What matters is whether they are taken consciously, understood, and managed continuously, or whether they affect the portfolio without being properly considered.
This reinforces the idea essentially expressed by Warren Buffett: risk does not arise from market fluctuations themselves, but from a lack of knowledge and an insufficiently systematic approach. Those who manage risks in a structured way have no reason to fear them. On the contrary, they create the conditions necessary for stable decision-making, especially when markets are volatile.
