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.

Pre-requisites

Course Progress

Course Glossary

Course
Orientation

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.

- Neil Simon

Take calculated risk

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.

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.

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.

$

 

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	%
Bonds	%
Large-Cap Stocks	%
Growth & Technology Stocks	%
Foreign Investments	%
TOTAL: 100%(must add to 100)

 

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

 

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!)

 

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%

Never

Return on risk

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?

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:

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

Example

Foreign investments

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:

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).

Reduce
unique risk through diversification

Systemic risk

Portfolio diversification

RiskGrade analysis

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 bonds fluctuate

Long term bonds are riskiest

Price fluctuations drive RiskGrades

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.

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

- Winston Churchill

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.

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

Standard
deviation

Interpreting volatility

Risk and return

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.

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:

Correlations affect portfolio risk

Dynamic correlations

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.

Comparable across assets

Risk tolerance

RiskGrades are dynamic

Example

Calculating RiskGrades

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.

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 Calibration       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: 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. 　 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.

Example

Diversification benefit

Risk Ranking

Get your own RiskGrade

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....

Example

Calculating
RiskImpact

Concentration risk

Using
RiskImpact

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.

Calculating XLoss

Example

Diversification benefit

Limitations of XLoss

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.

Module Objectives

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

The following summarizes five key RiskMetrics Rules for managing risk:

Case study

Diversification

Insurance

Hedging

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.

Keep your target risk level

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.

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

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:

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.

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

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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