Understanding Risks

Understanding Risk -Syllabus




Course Objectives
Welcome to the Understanding Risk course
Our goal is to make you a better investor by providing you with the same powerful risk analysis tools used by Wall Street professionals.
Personal investing has changed dramatically over the past quarter-century, especially in recent years. With today's growth and deregulation of global financial markets, combined with the rapid evolution of computing and communication, we see increasing reliance on personal investment rather than public and employer-financed retirement plans. In this new world, individuals have tremendous financial opportunities, but also face new responsibilities.

The Understanding Risk course has been developed to help you meet your long-term financial objectives by providing you with resources to understand and manage the risks along the way. The course reviews the fundamentals of risk and introduces you to the new leading edge tools developed by RiskMetrics for measuring risk.

After completing this course, you will be able to:

  • Understand the relationship between risk and opportunity
  • Identify and measure your portfolio's exposure to risk
  • Apply RiskGrades suite of advanced measurement tools to analyze your risk
  • Create an investment portfolio that matches your tolerance for risk
  • Manage your portfolio's risk on an on-going basis


For an overview on how the course is organized, please click the Next button below.








Course Progress


Course Glossary





Course overview
Preview the course structure and learning environment
The course is divided into the following three modules, each of which takes less than forty-five minutes to complete.

  1. Identifying Risk: emphasizes the importance of understanding and measuring risk before making decisions.


  2. Measuring Risk: introduces the fundamentals of quantifying market risk using the RiskGrades approach.


  3. Managing Risk: concludes the course with ways an investor can apply RiskGrades to manage risk.

The course has no pre-requisites except a keen interest to learn about risk. If you're already a risk expert, you may skip the fundamentals of identifying and measuring risk to go ahead and learn about the new RiskGrades suite of advanced risk measurement tools.

You can monitor your progress through the course at any time by clicking the Syllabus button in the toolbar on the left. Go ahead and give it a try. A small browser window will open up displaying links to every lesson, with a red highlight indicating your current location. This is a good way to preview the course.

A course Glossary is also available online and can be accessed at anytime by clicking the Glossary button on the left-hand toolbar. Glossary entries are found throughout the course and are indicated by italicized, underscored text. Clicking a glossary entry reveals a separate window containing a definition of the entry.

If you're interested in learning more about navigating through the course and using different design features, please review the course orientation.

Now that you're ready to learn about risk, click "Next" to begin the course.

B.Identifying Risk

The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.

- Peter Bernstein, Against the Gods

Introduction: The shifting paradigm of risk management
Learn how probability theory was invented and how it evolved into modern risk and decision theory

When Greeks threw dice in ancient times, they believed the outcome was predetermined by the gods rather than ruled by the laws of probability. The concept of risk as uncertainty did not yet exist.

The birth of modern risk management came in the 17th century, when Renaissance thinkers Pascal and Fermat invented probability theory while solving an intellectual puzzle. This theory gave us a newfound ability to make rational decisions about the future, and sparked many other discoveries. By quantifying uncertainty, we can make rational decisions about which risks are worth taking.

Advances in risk management theory have had a tremendous impact on global economic development. For corporations, the ability to measure and transfer risk made it possible to raise capital for large-scale investments. Similarly, individuals now have an unprecedented ability to take charge of their economic destiny, for example, through managing financial assets and liabilities, or by purchasing insurance.

When you complete this module, you will be able to:


  • Define and conceptualize risk
  • Explore the relationship between risk and opportunity
  • Understand your own risk preference
  • Identify, understand, and classify different types of financial risk


Risk is uncertainty

Risk and time


Risk and objectives

What is risk?
Learn how risk is defined, and how it relates to time horizons and objectives
Simply put, risk is uncertainty. The more risk you take, the more you stand to lose or gain. You cannot expect high returns without taking substantial risks.

It is important to take into account your investment time horizon when analyzing risk. The first question to ask when making an investment is: "When do I need the money?" In general, you can accept more risk if your investment horizon is longer. Why? Because you have more time to recoup potential losses along the way.

Risk should be measured against pre-defined objectives. Investors generally have either absolute return goals (e.g., 15% annual return) or relative return objectives (e.g., outperform the S&P 500 index by 1% per annum).

"If no one ever took risks, Michelangelo would have painted the Sistine floor."

- Neil Simon





Take calculated risk

Risk and opportunity
View risk as opportunity, and see how the ability to take calculated risk can convert potential pitfalls into gains
We can't expect to get anywhere if we avoid taking risk. History shows that great accomplishments have always involved taking significant calculated risks in one form or another. Great artists, investors, and entrepreneurs alike are willing to take risk because they see it as opportunity.

Rather than avoid risk entirely, avoid taking poorly understood risks. Take risk only when the upside justifies the downside. The ability to understand and measure risk will empower you to make better investment decisions.

As risk relates to the chance of losing or making money, it's clear that risk is not just a bad thing. In fact, risk can hold tremendous opportunities for those who know how to manage it. Those who can't stomach risk are guaranteed to miss out on opportunities. For example, proverbial mattress stuffers (i.e., the faint hearted who don't trust anything they can't sleep on) lose in the long run when inflation erodes their purchasing power.


Risk Profile Quiz
Risk Profile Quiz
Investors have different tolerances for accepting risk, take the Risk Profile Quiz and discover what your risk tolerance is
People will always have different preferences for risk taking. Some claim that we are born with a certain risk tolerance level, but then our appetite for risk tends to diminish as we grow older. It makes sense for a young person to take more risk. Chances are you'll need to keep your day job, but it doesn't hurt to entertain the possibility of making out big and sailing into the sunset early. Conversely, an 71-year-old has little incentive to risk the retirement nest egg.

So what's the right amount of risk to take? First, consider your risk preference. After all, what good is a profitable investment if it costs a heart attack along the way. Some are inherently comfortable with risks that make another's stomach churn. How would you feel if your portfolio lost a titanic 21 % in a single day (that's how much the S&P 500 fell on Black Monday in October 1987). Go ahead and take our Risk Profile quiz to discover your risk preference.

Risk Profile Quiz

The goal of long-term financial planning is to build an optimal portfolio that meets personal expectations of risk and return. The following set of questions is designed to provide an allocation mix that may be suitable for you.

  1. How much in savings have you allocated to achieving long-term investment objectives, i.e. equities, bonds, mutual funds, etc. Please enter a dollar amount.



  2. In the table below, please assign a weight to each asset class (in increments of 5%). Keep in mind that your total must equal 100%.

    % of Portfolio         

    Cash & Money Market Funds




    Large-Cap Stocks


    Growth & Technology Stocks


    Foreign Investments


    TOTAL: 100%(must add to 100)


  3. What is your investment horizon? In other words, when do you need cash from your current investments (e.g. college tuition, wedding, purchasing a home)?

    Less than 1 year
    1-2 years
    2-5 years
    5-10 years
    10-30 years


  4. What is your primary investment objective?

    Preserving Capital
    Generating Income (Outpacing inflation)
    Balancing Growth and Income (The prudent investor)
    Achieving Growth (Retire earlier than planned)
    Capturing Highest Potential Returns (Wild, Wild West!)


  5. How far does the market have to fall before you re-balance your portfolio? In other words, when would you begin to sell some of your positions?

    Less than 5%
    Between 5% to 10%
    Between 10% to 20%
    Between 20% to 35%


The world is return-focused

Return on risk

Risk and Performance
You need to consider risk to understand your investment performance
Historically, the focus of most investors has been on tracking returns, while neglecting how much risk was taken to generate the returns. Return information is ubiquitous in newspapers, Internet sites and financial statements, while risk information is difficult to come by. Every quarter, investors see popular magazine rankings of the highest returning mutual funds, with the implicit assumption that these were the best performing funds. However, in order to judge investment performance, we must understand how much risk was taken to generate those returns.
Is the highest return always the best return?
Return information can be misleading, as the following example illustrates.

Consider yourself the lucky winner of $100 Million cash in the NY Lottery. Your mother immediately tells you to get professional assistance to manage the windfall, and your helpful friends suggest two candidates. You give $50 Million each to Greater American Money Belt Lending Enterprises (GAMBLE) and Secure American Financial Enterprises (SAFE). Next year, GAMBLE returns with $60 million (giving you a return of 20%) while SAFE comes back with a measly $55 million (i.e., a 10% return). Who did better? From a return perspective, GAMBLE wins hands down. Before firing the other manager, however, you should find out how much risk each manager took to earn his returns. The picture looks different once you find out that your star performer gave your hard-earned cash to the local loan shark who happened not to default this year, while SAFE earned his returns through investments in a solid portfolio of US government notes.

This example shows how return information alone is insufficient, and it's essential to consider risk before judging investment performance.

The ability to include risk analysis in investment decisions allows investors to change their asset allocation in a way that enhances their return on risk. As we'll demonstrate later on, for most portfolios the return on risk can be improved: that means it is possible to either increase expected return while maintaining the same risk level, or to keep the same expected return while decreasing risk.

Rather than focusing on maximizing returns, the smart investor selects opportunities that are attractive based on their return on risk. This is important because sometimes the promise of a big return, simply may not be worth the risk.

Which apple would you pick?

The biggest apple is not always the best!

Considering risk should be an integral component of your decision making process


Importance of considering risk
Understand why you need to consider risk before making investment decisions
We pay a great deal of attention to risk in our personal life, but often make financial decisions without an appropriate understanding of risk. We look both ways before we cross the road. We research a company's prospects before we accept a job offer. We buy health, auto, life and homeowner's insurance. We need to apply the same risk management discipline when making financial decisions.

Making investment decisions without measuring the risks is the same as courting disaster. Think for a minute how absurd it would be to live your personal life without considering risk:


Need to quantify risk as you currently quantify return
As investors become more conscious of risk, they generally become more discerning in selecting suitable investments. Before investing, knowledgeable investors review formal risk disclosures in order to make more informed investment decisions. Some progressive money managers have already started to publish detailed disclosures about the risks they take.
A Hall of Fame Risk Disclosure
The following progressive risk disclosure of the IPS Millennium Fund was profiled by the Wall Street Journal in "Read This (and Invest) at Your Peril! Manager Tells Hard Truth in Disclosures" (January 21, 2000). The following are some excerpts:

First of all, stock prices are volatile. Well, duh. If you buy shares in a stock mutual fund, any stock mutual fund, your investment value will change every day. In a recession it will go down, day after day, week after week, month after month, until you are ready to tear your hair out, unless you've already gone bald from worry. It will insist on this even if Gandhi, Jefferson, John Lennon, Jesus and the Apostles, Einstein, Merlin and Golda Meir all manage the thing´.

While the long-term bias in stock prices is upward, stocks enter a bear market with amazing regularity, about every 3 - 4 years. It goes with the territory. Expect it. Live with it. If you can't do that, go bury your money in a jar or put it in the bank and don't bother us about why your investment goes south sometimes or why water runs downhill. It's physics, man´.

We buy scary stuff. You know, Internet stocks, small companies. These things go up and down like Pogo Sticks on steroids´. Sometimes we get killed ´ when Internet and other tech stocks take a particularly big hit. The "we" is actually a euphemism for you, got it? We also get killed if interest rates go up, because that affects high dividend companies badly. Since rising interest rates affect everything badly, we could get killed even worse if the Fed raises rates, or the economy in general experiences higher interest rates beyond the control of those in control, or gets out of control´.

Just so you know. Don't come crying to us if we lose all your money, and you wind up a Dumpster Dude or a Basket Lady rooting for aluminum cans in your old age.


While such "human language" on risk disclosures is unique to the IPS Millennium Fund, there is a universal trend among funds to make risks more transparent to investors.



In addition to better risk disclosures, investors should receive more quantitative risk information. While mutual funds provide precise return numbers, most risk disclosures are still vague at best. For example, most mutual funds convey their proclivity for assuming risk with only generic labels like, "aggressive," "balanced," or "moderate". Risk should be quantified as rigorously as returns. How would you feel if your mutual fund statements reported that your last quarter's returns as "conservative" or "moderate", instead of stating the actual return number?

Risk information is as important as return data, and should be updated and accessible on a daily basis (similar to Net Asset Value (NAV) calculation). The mission of RiskMetrics is to provide investors with updated daily risk measurement information for all traded financial assets.





Components of market risk






Foreign investments





Market Risk
Identify market risk and its four components
Observed every minute of each trading day, market risk is well known by all investors. Market risk arises from the fluctuating prices of investments as they are traded in the global markets. Market risk changes cyclically, from calm times to periods with wild price swings. RiskGrades were conceived to help investors measure their continually changing exposure to market risk.

RiskGrades measure the four subcomponents of market risk: equity risk, interest rate risk, currency risk, and commodity risk. Each investment you make will face one or more of these component risks.

For example, the table below shows the risks associated with each investment, from the perspective of a U.S. investor:

Investments Equity Risk Interest Rate Risk Currency Risk Commodity Risk
IBM stock
Bangkok Bank stock
5yr GE bond 8.25%
5yr US T-Note
Gold (CMX)

The market risk examples above are straightforward: owning stocks (IBM) exposes you to equity risk, owning bonds (GE bond and US T-Note) exposes you to interest rate risk, and owning commodities (gold) exposes you to commodity risk.

In some cases, however, an investment can be exposed to more than one component of market risk, simultaneously. For example, a U.S. investor who owns shares of a foreign stock like Bangkok Bank will be exposed to both equity and currency risk (i.e., potential loss arising from depreciation of Thai baht relative to US dollar).

RiskGrades measure total market risk, which often includes the effect of multiple subcomponents (i.e., currency plus equity risk as in the Bangkok Bank example).





Event risk
Understand how to identify event risk, specifically credit risk and liquidity risk
Event risk involves an unexpected and sudden shock that can arise from any general type of risk, such as company defaults, natural disasters, technology failures, human error, political upheavals, or war.

Events are difficult to predict, for obvious reasons: anything could happen. Once an event strikes, however, we know there will be aftershocks. Picture a rock falling into a lake. Risk models can't predict when someone is going to throw the rock in the lake, but they can estimate the ripple effect after impact.

Events are most troublesome when the aftershocks sets off a chain of similar events (i.e., the domino effect). Below is a brief illustration of the '97 Asian crisis and its aftereffects.


unique risk through diversification


Systemic risk




Portfolio diversification









RiskGrade analysis

Unique vs. Systemic Risk
Understand how to differentiate between systemic and unique risk
Risk is either unique or systemic. Unique risk is exposure to a particular company, and is sometimes referred to as firm-specific risk. Systemic risk (or systematic risk) is the risk of a portfolio after all unique risk has been diversified away.

You can minimize unique risk by spreading your investments, and avoiding an over-concentration in any single company, industry, or country. Studies show that reasonable diversification can be achieved with as little as a dozen stocks, and most unique risk can be eliminated with 50 stocks (less than 5% unique risk). Of course, this depends on your particular portfolio composition (e.g., 50 bank stocks are not a diversified portfolio).

When all unique risk is diversified away, investors are left with systemic risk. Systemic risks may arise from common driving factors (for example, economic factors, natural disasters, or war) and can influence the whole market's well being. A broad and diversified stock market index, such as the S&P 500, represents mostly systemic risk. Systemic risk cannot be diversified away (e.g., you cannot significantly reduce your risk by spreading your investments over 1000 stocks instead of 500).

The graph below shows how the unique risk of a portfolio of US equities declines with increasing diversification until all the risk becomes systemic. A RiskGrade of around 100 represents the average systemic risk of a diversified global stock index in normal market conditions.

RiskGrades measure total portfolio risk, which includes both systemic and unique risk. RiskGrades highlight risk concentrations and and quantify portfolio diversification effects. You'll learn more about RiskGrades in the next module, Measuring Risk.

Why stocks fluctuate


Why bonds fluctuate



Long term bonds are riskiest


Price fluctuations drive RiskGrades

Sources of risk
Learn why the price of stocks and bonds fluctuate
Why does the price of Coca-Cola shares fluctuate every day, when the price of Coca-Cola does not? Stock and bond prices are based on expectations of future profits and returns, which are ever changing and uncertain. The price which Coca-Cola sells its products today are only a small part of what goes into the share price of Coca-Cola. Every day, traders reassess the value of Coca-Cola shares based on what they expect Coca-Cola to earn over the foreseeable future, how sure they feel about their forecasts, and just as important, what they think other market participants' views are about Coca-Cola's future.

Bond prices, like stock prices, also depend on market views about the future. In contrast to stocks, however, bonds are tied more closely to views about the economy on a whole rather than the fortunes of individual companies. Since bonds pay a fixed interest rate, investors tend to focus on the interest rate, or more precisely, the yield, rather than the price of a bond. When interest rates in the economy as a whole rise, the price of a bond falls, since it pays a fixed coupon rate which is now below the market rate.

Longer maturity bonds are more sensitive to changes in interest rates, because the interest rate they pay is locked in for a longer period of time. Imagine you own a bond that pays 5% interest while the market rate is 6%. Would you rather be locked into a below-market interest rate for one year or 10 years? A 10-year bond is therefore much more risky than a 1-year bond.

RiskGrades are based on statistical analysis of historical price fluctuations of stocks and bonds (and foreign exchange rates and commodity prices). Large price fluctuations are an indication of high uncertainty, or risk. Learn more about measuring risk in the next module.



optimist sees opportunity in every danger; the pessimist sees danger
in every opportunity."

- Winston Churchill

Learn how to be an intelligent risk taker
Risk is an unavoidable fact of life and investing. When asked by a reporter about his view on the direction of the market, the venerable
J. Pierpont Morgan responded: "The market will go up and it will go down, but not necessarily in that order."

We need not fear risk or be passive victims of it. Risk is a natural part of this world, and indeed, risk can present great opportunities for those who understand and know how to manage it. Courtesy of long lineage of thinkers, we now have powerful ways to analyze risks and make prudent decisions about the future. We can identify and measure different types of risk, and decide which ones to take and which ones to avoid.

In this module, you learned that you need to be clear about investment objectives, time horizons, and risk preferences when analyzing risks. You should know that you take risk only if you can understand and measure it, and live with its downside. You also know that the returns must justify the potential downside of risk taking.

You should now be able to:


  • Define and conceptualize risk
  • Explore the relationship between risk and opportunity
  • Understand your own risk preference
  • Identify, understand, and classify different types of financial risk


Congratulations, you have just completed the first step in the continuous cycle of risk management: understanding and identifying risk. Click on the button below labeled "Next" to begin Module 3, Measuring Risk.


C.Measuring Risk


Quantification of Risk
Introduction: Why measure risk?
Understand why it's important to measure risk
As you learned in the previous module, you cannot make wise investments without first considering risk. To be successful, every investor must be able to identify and understand the types of risk they face across their entire portfolio. Measuring risk is just as important as measuring returns.

Our objective is to make you a smarter investor by offering the same risk analysis tools used by professional risk managers. Measuring risk on a portfolio basis will show you how well diversified your investments are, where the largest gains and losses are likely to be concentrated, and how your risk profile compares with that of your peers. Ultimately, the greater transparency achieved through measuring risk will help you make more informed investment decisions.

After completing this module, you will be able to:


  • Understand the meaning of volatility
  • Use the RiskGrade measure to benchmark your investment risk
  • Apply the XLoss measure to estimate your potential loss in extreme market conditions
  • Analyze the risk of your entire portfolio and determine how well diversified your investments are
Understanding volatility



Interpreting volatility


Risk and return

Learn how to interpret standard deviation as a measure of volatility
In the financial world, risk is often expressed as volatility of returns. Volatility measures how variable outcomes are likely to be. For example, when you throw a dice, you know that the result will range from one to six. Similarly, when you buy an investment, its price volatility characterizes its range of returns.

Standard deviation is a general statistical measure of volatility. It measures historical variability of returns from their mean. A higher standard deviation implies more variable and uncertain returns. Standard deviation has been a classical portfolio risk measure since Nobel laureate Harry Markovitz used it in the 1950s to demonstrate risk reduction through diversification.

Given that in 1999 the daily standard deviations of returns for the S&P 500 Index and Yahoo! were 1.1 % and 5.6 % respectively, one can venture that Yahoo! was a much riskier investment than the S&P 500 Index. In fact, Yahoo!'s returns were around five times (or precisely 5.6/1.1) as volatile as the S&P 500 Index. But if Yahoo! was five times riskier, why did it outperform the S&P by 229 %? That's because risk cuts both ways.

Investing in Yahoo! stock means that you are more likely to experience sudden large drops in value, but you also stand a chance to achieve a higher return. Go ahead and compare Yahoo!'s biggest daily return and drop (+13.5 % and -23.5%) against the S&P 500 (+2.8 % and -3.5 %) in the table below. Higher volatility means higher gains AND losses. You can see the same pattern when you look at General Electric (GE) a more stable Blue Chip that isn't as risky as Yahoo!, but is still much riskier than the diversified S&P 500 Index.

Investment 1999 daily standard deviation 1999 return 1999 biggest daily upswing 1999 biggest daily drop
S&P 500 Index 1.1 % 19.6 % 2.8 % -3.5 %
Yahoo! stock 5.6 % 248.9 % 13.5 % -23.9 %
GE stock 1.8 % 55.8 % 5.8 % -4.4 %
Correlation measures comovement


Understand the concept of correlation and its effect on portfolio risk.
Whereas volatility shows how risky individual assets are, correlation measures how closely individual assets are interrelated. Correlation is calculated by observing historical comovement in returns, and measured on a scale between -1 and 1.

The following Flip book simulates the daily price changes of two different stocks. Plotting the price changes for both stocks over time allows you to visualize how returns move relative to each other:

Interpreting correlation




Correlations affect portfolio risk


Dynamic correlations

A correlation of 1 means that returns move together perfectly, whereas a correlation of -1 implies perfect opposite movement. A 0 (zero) correlation implies independence. We generally observe positive correlations within an asset class (for example, within equities), and in particular within the same country and industry (e.g., US technology stocks). Note that high correlation between two assets does not imply that they are directly linked to each other. They may just be driven by similar factors, such as interest rates and oil prices.

Correlations are a key driver of total portfolio risk. Portfolio managers look for assets with low (or even negative) correlations to achieve better diversification. For example, international investments often yield high diversification benefit due to low correlation of currency rates with other assets.

Investors should be aware, however, that correlations are dynamic and often change during turbulent market conditions, which may dramatically impact portfolio risk.

Correlations are constantly changing, and in turbulent times they may even dramatically reverse from positive to negative.

For example, while we generally observe positive correlations between stocks and bonds, this relationship is not stable. Note in particular how the normally positive correlation between stocks and government bonds suddenly turned negative in October 1997, when there was a high stock market volatility. We attribute this reversal of correlation to the flight to safety phenomenon, where investors exit stock en masse in favor of bonds.

Changes in correlations can have profound impact on market risk. Interestingly in the case above, an investor holding both the S&P 500 and US 10 Year notes would have experienced a higher diversification benefit as correlations reversed during the October '97 crisis (porfolio risk reduction when it counts: while stocks fell, government bonds appreciated). On the other hand, your portfolio risk would have increased if you held the S&P 500 but had a short position in US 10 year notes.

The dynamic nature of correlations (and volatilities) shows that it's important to update risk models constantly to reflect current market conditions.



A universal risk measure




Comparable across assets



Risk tolerance





RiskGrades are dynamic













Calculating RiskGrades

Introducing RiskGrades™
Understand RiskGrades and learn how to use them when comparing the risk of different assets
RiskMetrics introduced RiskGrades to address investors' need for a consistent and reliable way to measure market risk. RiskGrades are a new statistic that allows for risk comparison across all asset classes. Like standard deviation, RiskGrade quantifies the volatility of financial assets. RiskGrades, however, are calibrated to be more intuitive and easier to use than standard deviations. RiskGrades can range from 0 to over 1000, where 100 corresponds to the average risk of a diversified market-cap weighted index of global equities.

RiskGrades are a standardized measure of volatility, and therefore allow an "apples to apples" comparison of investment risk across all asset classes and regions. Thus, we can say that a Brazilian stock with a RiskGrade of 300 is six times as risky as an Asian Bond Fund with a RiskGrade of 50. Furthermore, RiskGrades capture all components of market risk: equity, interest rate, currency, and commodity risk.

The RiskGrade scale below compares the relative risk of some major asset classes. Conservative investors usually don't venture much beyond major government bonds, which typically have a RiskGrade below 30, while aggressive investors are comfortable with high tech stocks like Yahoo!, which often have RiskGrades in excess of 300.

RiskGrades are not constant through time, and adjust to current market conditions: during turbulent times, such as the Asian Crisis or the Russian devaluation, RiskGrades of major stock markets can easily escalate beyond 200 to reflect higher risk, while calmer markets could yield RiskGrades below 80.

Evolution of RiskGrades through time
RiskGrades change constantly to reflect current market risk. During crises, RiskGrades spike up and then slowly settle down as markets calm.

RiskGrades dynamically gage market volatility. It's immediately clear from the graph below that Brazilian stocks (BOVESPA index) are generally far riskier than US stocks (S&P 500 index). Ranging from 110 to 550, BOVESPA RiskGrades are consistently higher than S&P 500 RiskGrades (90 to 180 range). As an Emerging Market, Brazil is very sensitive to exogenous market shocks, such as the '97 Asian Crisis, and '98 Russian Devaluation (notice the spikes in RiskGrades). Not surprisingly, Brazil's risk peaked with its currency devaluation on Jan 13 1999. Notice also that all shocks resulted in a rapid escalation of risk: events rarely come alone, but rather are followed by a rapid succession of aftershocks. We call this effect volatility clustering.

As the graph above shows, risk is fluid and can spread rapidly like a global storm, encompasing both emerging and developed markets. Given a significant event, such as a major currency devaluation or stock market crash, RiskGrades could easily double overnight. Investing in any given asset does not always carry the same risk. For example, holding U.S. stocks during the Russian crisis in October 1998 was over 50% riskier than in April 1998 or April 1999, when markets were closer to normal (i.e., with S&P 500 RiskGrades around 100). Emerging markets in particular (e.g., Latin America, Eastern Europe, Southeast Asia) are prone to extreme risk escalations.

RiskGrades can help investors monitor their ongoing exposure to market risk, which is ever-changing. RiskGrades are a benchmark for the level of current market risk (e.g., is it above or below average?). And while RiskGrades cannot predict unforseen events, they quickly adapt to reflect impending aftershocks (i.e., volatility clusters).


Below you can plot the evolution of RiskGrades for a diversified equity index (S&P 500), a Blue Chip stock, General Electric (GE), and a technology stock (Yahoo!):

Mouse-over the line chart above to see each asset's historical RiskGrade measurement

Want to know how we calculate RiskGrades?

Historical volatility


Similar to standard deviation


Exponential weighting





Transparent risk benchmark

How we calculate RiskGrades
RiskGrades are forecasts based on the analysis of historical market volatility. Rather than predict which way the market moves (e.g., whether the S&P 500 moves up or down next month), we forecast how large market movements are likely to be (e.g., what is the chance of the S&P 500 moving by more than 10% next month). Risk estimates are generally much more stable and reliable than directional forecasts, and allow high-confidence risk forecasts (between 95% to 99% confidence).

As a measure of volatility, the calculations behind RiskGrades are similar to standard deviation. RiskGrades are derived by observing how much past returns have deviated from their mean. However, there are two main differences between RiskGrades and simple standard deviations:

  1. The first is that RiskGrade estimates are based on exponential weighting of historical data, which makes them more adaptive to current market conditions than plain standard deviations. When J.P. Morgan released the RiskMetrics methodology, it revealed a series of studies that demonstrated that exponential weighting significantly improved forecasting accuracy and responsiveness in extreme market conditions.

  2. The second difference is that RiskGrades have been calibrated for easier interpretation by the general public. A RiskGrade of 100 is scaled to reflect 20% annualized standard deviation, which was the average volatility of (market-cap weighted) global equities from January 1995 to December 1999. Hence a RiskGrade of 100 is generally our baseline for normal equity market risk, and can be used to compare all other investments (e.g., a bond fund with a RiskGrade of 33 is about a third as risky as a diversified global portfolio of stocks during normal market conditions).


To promote RiskGrades as a transparent global benchmark for measuring risk, RiskMetrics publishes the complete methodology, available in the form of a RiskGrades Technical Document, for free download over the Internet.


Total portfolio risk








Diversification benefit





Risk Ranking







Get your own RiskGrade

Using RiskGrades to measure portfolio risk
Learn how to apply RiskGrades to measure and interpret your own portfolio risk
RiskGrades allow you to measure the risk of a single asset or your entire portfolio. You can spot your riskiest holdings, evaluate your overall portfolio risk level, and compare your risk against others.

In the sample portfolio below, Yahoo! stock is by far the most volatile holding: it's RiskGrade of 400 is more than twice as high as GE's 195 RiskGrade. The second riskiest is the Internet Fund (WWWFX), whose 262 RiskGrade is about twice as volatile as the Vanguard's S&P 500 Fund (VFINX). Cash carries a RiskGrade of 0, since it has no market risk. In this example, your total portfolio RiskGrade is 154, which means that you can expect its value to be around 1.54 times as risky as a portfolio of global stocks during normal market conditions.

Your total RiskGrade will always be less than the weighted average of individual RiskGrades due to diversification. You can significantly reduce risk by holding many independent assets instead of just a single stock. The diversification benefit for your portfolio RiskGrade is simply the difference between the computed portfolio RiskGrade and the market-value weighted average of the individual asset RiskGrades. For example, the above diversification benefit of 43 shows that diversification has made the portfolio about 22% less risky (i.e., without diversification the portfolio would have had a RiskGrade of 154 + 43 = 198, so the percentage risk reduction was 43/198 = 22%).

When evaluating how much risk you're taking, you may find it interesting to compare your risk level against others:

For example, the above Risk Ranking implies that Joe R. Grade's portfolio was below average compared to his peers (55% took more risk, 45% took less risk).

Do you know how risky your portfolio is, and how it compares against others? Go ahead and click on the "My Portfolio" link located on the top left frame to find out. You may be surprised....
















Concentration risk





Introducing RiskImpact
Understand how to measure the RiskImpact of your investments
RiskImpact measures how much risk a position contributes to the overall portfolio. Investors can use RiskImpact to identify concentration risks and preview the change in the portfolio's RiskGrade if a position were to be sold.

In the portfolio below, Yahoo! contributes a disproportionate amount of risk: its RiskImpact is 38%, even though its Market Value is only 20% of the portfolio's total value. It makes sense when we consider that Yahoo! is by far the most volatile stock, with a stand alone RiskGrade of 400. The next highest risk contribution comes from the Internet Fund (WWWFX): if we removed it, Portfolio RiskGrade would drop by 26%. On the other hand, GE and VFINX both help diversify the portfolio, as you can see by their relatively low RiskImpact.

How do we calculate RiskImpact? We basically take the difference between the RiskGrade of the portfolio with and without the position:

RiskImpact = Portfolio RiskGrade - Portfolio RiskGrade without position

To report RiskImpact as a percentage of the RiskGrade of the entire portfolio, we simply divide RiskImpact by the Portfolio RiskGrade.

RiskImpact is important because it shows how an individual position affects the overall portfolio risk. A relatively minor position could have a significant RiskImpact if it is (a) highly volatile, and (b) strongly correlated to the rest of the portfolio. In general, the less correlated an asset is to the rest of the portfolio, the lower its RiskImpact (and the greater the diversification benefit). Thus in the US sample portfolio above, adding another US stock would have a higher RiskImpact than adding a Japanese or European stock with a comparable RiskGrade.

By quantifying the marginal risk of each position, RiskImpact helps identify overconcentrations in particular assets or asset classes. Investors can use RiskImpact to analyze new transactions and to keep the portfolio balanced.



Extreme market risk


Calculating XLoss












Diversification benefit

Limitations of XLoss

Introducing Loss-in-Extreme-Markets (XLoss)
Apply XLoss to measure your loss potential in adverse markets
To address the question of how much money you could lose due to adverse market movements, RiskMetrics introduced a statistic called Loss-in-Extreme-Markets (XLoss). XLoss measures your expected loss in extreme market conditions, where returns exceed the forecasted 95th percentile worst-case loss level.:
Coke's daily price changes
















Calculating XLoss















Interpreting XLoss

XLoss Animation (non Flash)
1. The animation begins with the observation of Coke's daily stock price changes over the past 20 years. Losses are indicated in red, while gains are green (first graph). We take these gains and losses to draw the Coke Return Distribution, and fit the bell shaped Normal Distribution on top of it (second graph)

From the roughly equal proportion of daily gains and losses in the return graphs above, we can see that Coke investors stood close to a 50% chance of making or losing money over a 1 day horizon. In general, you can only expect to earn positive returns on stocks over a much longer investment horizon (e.g., 10 years or more).

2. Next, we focus on the worst 5% daily price changes of the Coke return distribution, and determining XLoss by averaging of these losses:

In this histogram of the worst 5th percentile daily losses we see that losses have ranged from less than -2.5% to over -10%. The XLoss statistic of -3.41% is the average of these worst case daily losses. In other words, Coke investors stood a 5% chance of incurring losses of -3.41% on a daily basis (i.e., on average, 1 out of 20 days Coke investors could expect a daily loss of -3.41%). Savvy investors can weigh short term Xloss potential against expected long term growth prospects for the stock.



Just like RiskGrades, we calculate XLoss for all your holdings and your combined portfolio. You can use the XLoss statistic to estimate how much you might lose over a specified time horizon, such as one day or one month. For our portfolio below, Yahoo! has the highest daily XLoss ($1,003), followed by WWWFX ($674). Across the entire portfolio, we can expect to lose $2,198 on a bad day (i.e., 5% of the time, or 1 in 20 trading days). You can use XLoss to test your risk tolerance: would it churn your stomach to swallow losses of that magnitude in a single day? If so, you may want to reduce your positions.

Due to diversification, XLoss will always be less than the sum of individual-asset XLosses. It is unlikely that all your worst-case losses would occur on the same day. XLoss diversification benefit is just the sum of the individual-asset XLosses minus the portfolio XLoss (e.g., $3,131 - $2,198 = $933 in the above portfolio).

XLoss is a good indicator of losses you might experience in adverse markets. Beware, however, that you may experience even larger losses on occasion. Remember that XLoss is your expected 95% confidence worst case loss, not your 100% worst case loss. Also keep in mind that the XLoss statistic is based on observed historical losses, which may not be indicative of future losses if there are radical shifts in the company's business or the overall market.

Understand the importance of taking a portfolio perspective in measuring your risks
Risk measurement is an essential step in the cycle of risk management. Without the ability to quantify your risk, you cannot be fully conscious of potential outcomes and the likelihood of winning or losing. Would you play a game of roulette without knowing the odds first? Risk statistics distill vast amounts of historical information to help you make better decisions about the future.

Risk measurement is particularly powerful on a portfolio level. While you may have an intuition about individual stocks, it is difficult to visualize how many different investments are likely to move together without portfolio risk analysis. And remember, these numbers are real. When you make an investment, there will be bad days and months where XLoss will have a visceral meaning.

You should now be able to:


  • Understand the meaning of volatility
  • Use the RiskGrade measure to benchmark your investment risk
  • Apply the XLoss measure to estimate your potential loss in extreme market conditions
  • Analyze the risk of your entire portfolio and determine how well diversified your investments are

Tested in academia and on the trading floors of Wall Street, RiskMetrics now gives you the same powerful risk analysis tools to help you make better investment decisions and sleep more peacefully at night.


D、Managing Risk




Module Objectives

Learn how you can take control of your financial future
Managing risk is an ongoing decision-making process with multiple dimensions. It involves continually searching out and understanding risks, measuring them, and managing them.

Managing risk can be viewed on many levels, from the micro decisions of making new investments to the more strategic perspective of achieving your long term investment objectives. Rather than advise on what investments you should or should not be making, this module reviews the basic options for changing your risk profile, and how RiskMetrics tools can be applied to analyze new transactions.

After completing this module, you will be able to:


  • Identify the principles of sound risk management
  • Use three basic strategies for changing your risk profile
  • Understand the benefits of diversification
  • Stress test your portfolio to reflect abnormal market conditions
RiskMetrics Rules for managing risk
Understand five key principles for managing risk
Managing risk is a combination of art and science that should incorporate a number of basic characteristics. Fundamental to properly managing risk is making risks transparent (or visible) through rigorous analysis and keeping risks balanced by applying disciplined judgments for all investment decisions.

The following summarizes five key RiskMetrics Rules for managing risk:




Case study













Three strategies for managing risk
Understand the three basic strategies for managing financial risk: hedging, diversification, and insurance
There are three fundamental techniques for managing financial risk:
1. Diversification
Reduce risk by investing in a large number of independent assets.
Example: Most investors diversify by holding a variety of stocks and mutual funds.

2. Insurance
Purchasing insurance involves paying a premium to protect against unfavorable events.
Example: GE stock investors can buy a put option to protect against the stock falling.

3. Hedging
Eliminates exposure by entering into an offsetting position.
Example: You can hedge S&P 500 exposure by shorting S&P Depositary Receipts (SPY).

Let's illustrate these three risk reduction techniques with a simple case study. Tired of paying exhorbitant NY rents, Jane G. decides to buy her first apartment. To ensure she can make the downpayment, she would like to reduce the risk of her highly speculative portfolio (below).



Given her shorter investment horizon and greater need for capital preservation, she now targets a RiskGrade of 80.

First, she diversifies her assets by re-allocating half of the portfolio to cash and bonds. Her risk falls by more than half: the new portfolio RiskGrade drops to 135 and XLoss declines to $3,111.

Next, she reduces her exposure to Cisco, her largest investment. Instead of selling the stock, however, she buys a put option to insure against Cisco falling below $60 without sacrificing upside potential. Her RiskGrade is now down to 88 and XLoss is $1,967.

Still above her target RiskGrade level of 80, Jane hedges her S&P 500 exposure by selling S&P Depositary Receipts (SPY). Her risk level is finally at an acceptable level, with a RiskGrade of 78 and XLoss of $1,728.

Benchmark yourself
Comparison with peers

Comparison with other indices



Keep your target risk level

Managing risk with RiskGrades
Understand how to target appropriate levels of risk by benchmarking yourself against peers and indices
How do you know when you're taking too much risk? Or not enough? To start managing your risk you first need to define a target risk level that is consistent with your goals, capacity for taking risk, and risk tolerance (see Risk Preference Questionnaire). Benchmarking yourself against peers, indices, and common asset allocations can also provide valuable perspective. Is your risk level within norm or an outlier?

When we first met him, Matt S. Tuffer was fatalistically waiting for an apocalyptic market crash while making measly money market returns. But after taking Understanding Risk, he realized that risk could be viewed as opportunity, and that not taking enough risk only guaranteed his long term underperformance. He then targeted a RiskGrade of 30 by allocating a portion of his assets to mutual funds. While still conservative, with a Risk Ranking of 22% relative to peers (e.g., 78% are taking more risk), Matt is now confident of achieving his investment goal of generating income without excessive volatity.

Wanda Lottery is another story altogether. With her margined Internet stock portfolio, her RiskGrade peaked at 1100 (yes, that's eleven times normal equity market risk!). Her Risk Ranking revealed that 99% of stocks in the NASDAQ 100 had a lower RiskGrade than her portfolio, and that 98% of investors took less risk. No wonder her portfolio behaved like a rollercoaster on steroids: her December 1999 ICGE stock investment tripled in that month and then lost over 80% of its value within the next three months. Having learned that laws of gravity can apply to Internet stocks also, she de-leveraged and diversified her portfolio. While still aggressive, she now has a more palatable RiskGrade of 156 and a Risk Ranking of 80%.

Where should you be? Take enough risk to position yourself for long term growth, but not more than you can digest. Keep in mind that you can't expect higher returns without higher risk. And beware that the risk inherent in your current investment mix is likely to change over time because risk is not static (e.g., over the last five years, S&P 500 RiskGrades have ranged from 50 to 150, NASDAQ's from 100 to 300). You can, however, target a stable risk level by managing your asset allocation to reflect the current level of market risk (i.e., hold a lower proportion of risky assets, such as stocks, when market is volatile). Furthermore, you should gradually reduce your risk as you approach your investment horizon (e.g., buying a home, paying for children's school, retirement).

The graph below illustrates how the target RiskGrades of an aggressive, moderate and conservative investor might evolve as they approach their investment horizon.

Keep risks balanced
Risk Impact
Understand the benefits of portfolio diversification for long-run stability
Savvy risk managers continually search out excessive concentrations in order to promote diversification and stable investment growth. Rather than mixing investments randomly, you can assemble investments which collectively perform well under different economic conditions, such as stocks and bonds (i.e., while stocks fare best in periods of economic expansion, bonds often do better in recessions).

The RiskImpact measure is useful for identifying excessive concentrations. Beware that the largest concentrations may not come from the largest positions or RiskGrades. In the sample portfolio below, Yahoo! has the highest RiskGrade (386), but SUN actually contributes more to the overall portfolio risk with its 31% RiskImpact.

You can also use RiskImpact to analyze how portfolio risk changes when you add new investments. Go ahead and see what if we bought $10,000 of NT (Northern Telecom).

Given the technology laden sample portfolio above, it should not be surprising that adding technology stocks such as NT increases risk much more than adding less correlated investments, such as bonds, diversified mutual funds, or traditional Blue Chips. For example, adding BA (Boeing) to the portfolio above only marginally increases risk and more than doubles Diversification Benefit.



Historical Events








Stress your portfolio



Two basic approaches



Stress testing
Understand how to stress test your portfolio for abnormal markets
While risk statistics work well for estimating risk during normal market conditions, they cannot predict the occasional, unexpected crises that result in extreme market shocks. To address this issue, we recommend stress testing.

RiskMetrics research has identified historical stress scenarios that have resulted in the largest losses for a diversified global portfolio consisting of 60% equities and 40% fixed income. The following historical scenarios resulted in the largest one- and five-day portfolio losses:

Crisis Date 1-day loss 5-day loss
Black Monday 19-Oct-87 -2.2% -5.9%
Gulf War 3-Aug-90 -0.9% -3.8%
Mex Peso Fallout 23-Jan-95 -1.0% -2.7%
Asian Crisis 27-Oct-97 -1.9% -3.6%
Russia Devaluation 27-Aug-98 -3.8% -2.6%

Many investors, including professional money managers, lost much more money during these days because their portfolios were not as well diversified. For example, the once-famed LTCM hedge fund, lost over 80% of its value during the '98 Russia Devaluation, because of excessive leverage and overconcentration.

These events highlight the importance of stress testing your portfolio to get an idea of how badly things could go during a crisis and to assure that losses do not exceed your loss-tolerance level. Similar to stress testing buildings and bridges under extreme environmental conditions, investors should stress test their portfolio to see if it can withstand adverse market conditions.

The basic question stress testing seeks to address is: "how much could I lose during a crisis event?" There are two basic ways to go about answering this question. The first is historical stress testing, which estimates how your portfolio would fare if you relived past events, such as the '87 stock market crash. The second approach is to invent your own extreme scenario based on what you think might go wrong in the world. The difficulty with these approaches is that (a) history is unlikely to repeat itself, and that (b) we don't have a crystal ball for predicting the future. Nonetheless, the discipline of stress testing allows you to consider your tolerance for loss and provides reference points for how bad things could get.

Module Conclusion
Know that you can take control of your financial future by managing your risk
Online trading has empowered individual investors to make their own financial decisions. With this freedom also comes the responsibility of sound risk management, which plays an increasingly important role in our economic well being.

Your investment goals, time horizon, risk preference, and market views will determine your target risk profile, which could mean taking more or less risk. Stress test your portfolio to ensure it can withstand unexpected shocks. Avoid excessive concentrations and promote diversification though balanced asset allocation. Keep in mind the virtues of disciplined long term investing: resist the temptation to time the market in favor of consistent, gradual investment. Use RiskGrades analytics to explore and measure your risk, and make sure that it is consistent with your target risk profile.

You should now be able to:


  • Apply the RiskMetrics rules for managing risk
  • Use the three basic strategies for changing your risk profile
  • Understand the benefits of diversification
  • Stress test your portfolio to reflect abnormal market condition


Course Conclusion

Congratulations on completing Understanding Risk! In this brief overview course, you have built a foundation for learning more about managing your investment risk. We invite you to find more about the standard setting risk management research, data and application brought to you by the RiskMetrics Group. We hope you take full advantage our leading-edge tools to better understand, measure, and manage your risk.

We hope that you found Understanding Risk a valuable and enjoyable learning experience. Please take a few minutes to answer several questions regarding the overall organization, presentation, and quality of the course material. Your input will enable us to better deliver the content that you want to see.

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