4.3. SUMMARY

Risk management is frequently misunderstood to be an exercise designed to reduce risk. It is really about the selection and sizing of exposures, to maximize returns for a given level of risk. After all, reducing risk almost always comes at the cost of reducing return. So, risk management activities must focus on eliminating or reducing exposure to unnecessary risks but also on taking risks that are expected to offer attractive payoffs. This is true whether one uses a systematic investment process or a discretionary one. The main difference between the two is that quants typically use software to manage risk, whereas discretionary traders, if they use software in the risk management process at all, primarily attempt merely to measure risk in some way, without any systematic process for adjusting their positions in accordance with predefined guidelines.

Exhibit 4.1. Schematic of the Black Box

Whether a quant uses a theoretical or empirical risk model or some hybrid thereof, the goal is the same: The quant wants to identify what systematic exposures are being taken, measure the amount of each exposure in a portfolio, and then make some determination about whether these risks are acceptable. What is good about these kinds of analyses, along with many of the other quantitative risk-modeling approaches, is that they require the quant to be intentional about risk-taking, ...

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