When it comes to your investment portfolio, preparation is key. Understanding how events will impact the financial outcomes of your portfolio will help you protect your investments and maximize your revenue.
The economist Frank Knight once said, “if you don’t know for sure what will happen, but you know the odds, that is risk. If you don’t even know the odds, that is uncertainty.”
To bring your investments out of the realms of uncertainty and help manage risks, you will need to partake in some kind of financial risk modelling. Otherwise, you leave your investments vulnerable to specific market downturns and instability.
What is Financial Risk Modelling?
Financial risk modelling, at its core, is the term used to describe techniques that analyze the risks present in investment portfolios. Under this umbrella term are techniques that analyze market risks, interest rate risks, inflation risks, and credit risks.
Two Types of Risk
There are two types of risks that financial risk models attempt to analyze and predict. Systematic risks and unsystematic risks.
Systematic risks are risks that are likely to impact every investment across a portfolio. These risks cannot be offset by diversification Unsystematic risks, on the other hand, are more specific and limited to individual asset classes or markets. This could include interest rate risks, inflation risks or political risks that affect a specific country’s markets.
How to Perform Financial Risk Modelling
Many groups will have their own techniques, methods, and software for modelling the effects of potential risks on market classes and portfolios. For example, you are able to maximize your retirement savings with the Entrust Group through access to the group’s risk modelling software.
Regardless of the methods and the software, financial risk modelling attempts to identify the host of parameters that would create a specific outcome and assess the dependency each portfolio is on each parameter.
Once these parameters have been identified and the dependency calculated, the financial risk model will assess the probability that these parameters could be disrupted or changed, therefore, assessing the probability that the outcome will be altered.
What Does This Mean in Real Terms?
In real terms, this means that if you want an annual minimum return on your retirement savings of 8%, a comprehensive financial risk model will analyze the probability and factors that will contribute to this outcome.
For example, the model may determine that to achieve 8% growth in your current investment portfolio, you would require a 3% growth in the domestic market and a 5% growth in the profitability of exports. It would then go on to examine the probability that these would take place.
Through financial risk modelling, investors are able to asses the risk of their investments and optimize their portfolio based on their appetite for risk and pursuit of returns. The results of financial risk modelling could indicate that the investor should further diversify their investment portfolio, hedge their investments, or reduce investments in a particular market. All of which would be undertaken to reduce the level of risk or mitigate the damage of potential market volatility.
