Risk: Operational vs Investment Risk

Successfully managing risk is key to achieving investment success. There are two major risks – Investment & Operational – and it is important that both are being properly assessed and monitored.

Risk = (probability of a negative event occurring)

            x (financial loss per event)

Successfully managing risk is key to achieving investment success.  There are two major risks and it is important that both are being properly assessed and monitored.  

Investment Risk – Quantitative

Nobel laureates and leading finance practitioners have devoted entire careers to assessing investment opportunities from a risk reward perspective. The last few decades have witnessed an entire subset of finance focused on the assessing hedge funds from a risk reward paradigm. It is well accepted that hedge fund returns do not follow a normal distribution pattern as is often the accepted basis of traditional finance and analytical tools. New tools and mathematical formulas have focused solely on evaluating risk adjusted returns using specific hedge fund parameters.

Investment risks are those risks associated with the investment decision and dependent upon the manger’s skill to capture alpha. Investors hire mangers to achieve alpha and manage investment risk.

Operational Risk – Qualitative

Evaluating operational risks is a qualitative exercise and investors need to manage this risk which can be due to weak accounting and internal controls or inadequate infrastructure of the manager’s and/or service providers operations. The result of poor operations or a weak control environment can materialize as fraud, errors in NAV calculations or a host of other unpleasant results.

The field of operational due diligence where operational risks are methodically evaluated is relatively new compared to traditional finance. Operational due diligence employs aspects of accounting, legal, compliance and operations in order to draw an accurate map of the operational risks associated with a particular investment.