The ChoosaBroker Trading Academy
4.3. Risk Management
Risk and return are the yin and yang of investing – intricately interwoven and inextricable. The Oxford English Dictionary defines risk as “the possibility of financial loss.” The greater is the risk involved in an investment, the greater can be the potential loss in value. This brings us to the important question of how tolerant are you of investment losses? Odds are, you don’t have a clear idea. Financial risk and its management can be a tricky subject; more so if you have limited investing experience under your belt. Through this lesson, we will try to clear some of those cobwebs by understanding the following key concepts:
What is Risk Management?
Risk management can be defined as the process of identifying, analyzing and accepting potential risks associated with an investment, and taking pre-emptive measures to curb them.
Investing without risk management is like being a quarterback without a front line to shield you – eventually you are bound to get slaughtered. Anytime you invest, you assume certain risks. Insured bank assets like certificates of deposit are open to inflation risk. Investments that aren’t insured like stocks and commodities carry the risk of loss of capital. However, just because you accept investment risks doesn’t mean that you can’t exercise some control over what will happen to the money you invest. If you recognize the types of risks that come latent with the different investments, make choices about those you are willing to undertake, and understand how to construct and balance a portfolio so that the impact of uncertainty is reduced, you are managing investment risk to your advantage.
Various Types of Financial Risk
Most investment risk can either be attributed to systematic or non-systematic factors. While these terms may seem intimidating, what they actually refer to is pretty straightforward.
Systematic risk is composed of risks that affect the overall economy or the entire market ecosystem. Also known as “market risk,” it can involve both domestic and international factors. Detailed below are some of the most common varieties of systematic risks.
- Interest Rate Risk – It refers to the risk that the value of an investment will go down because of fluctuations in interest rates. For example, when there is an increase in the general interest rate, new bond issuers are forced to offer higher coupon rates to draw investors. This consequently leads to a fall in the prices of existing bonds because investors opt for the newer bonds paying the higher coupon.
- Inflation Risk – It denotes the risk of a loss in purchasing power because your investment’s value fails to keep up with the prevailing inflation. Inflation risk is rife in cash and debt investments like bonds. Stocks and commodities generally offer protection against inflation.
- Currency Risk – It comes in to play only if an investor chooses to invest in international securities. Currency risk results from changes in the exchange rate between different currencies. If money needs to be converted from one currency to another to make an investment, any change in the exchange rate has the potential to inflate or deflate your investment return.
- Liquidity Risk – It represents the risk that an investor might not be able to buy or sell a financial asset quickly enough without impacting its market price. Liquidity risk is typically higher in over-the-counter markets.
- Geopolitical Risk – Geopolitical risk is the likelihood of unrest or instability in one or more of the regions of the world affecting your investment’s value. Terrorist attacks, unexpected changes in governments, breakout of war are all examples of such events. Notably, geopolitical risk can stem from both actual and anticipated events.
Non-systematic risk is the type of risk associated with investing in a particular asset, company or sector. The two most widespread non-systematic risks are briefly explained below:
- Credit Risk – Also called “default risk,” it refers to the risk that a borrower may not be able to repay a loan, resulting in the lender losing the principal invested and the interest receivable. Credit risk generally occurs on account of poor financial health of the borrower. It is most noticeably present in bonds and insurance investments.
- Management Risk – It is specific to equity-linked investments, and relates to the impact that bad management decisions can have on a company’s financial performance, and by extension, on the value of investments in that company.
Principles of Risk Management
Investment risk management is based on three core principles that can be applied in every market and at all times.
Principle 1 – Prediction is Difficult
Investors earn returns for correctly predicting the price direction of underlying assets and markets. Every prediction comes embedded with a margin of error. The risk management process seeks to understand these margins of error, and then use this understanding to assist in the investment decision-making process.
Principle 2 – Clarity is Imperative
Determining the kinds of risk you are comfortable taking is imperative. Since it’s practically impossible to avoid investment risk, the goal should be to establish the level of risk that is appropriate for you and then base your investment decisions accordingly. In general, the younger an investor is, the more risk he or she can afford to take. This is because the investor will have more time to make up for any losses that accumulate in the short term.
Principle 3 – Investing is Not a Clearly-Defined Game
At the start of the 20th century, there were 36 active stock markets in the world. Quite a few of those perished during the course of the past 100 years. Over longer periods of time, history shows that the number of financial markets that ultimately failed to survive is still greater. Even those markets that have continuously been in operation, the governing rules were in constant flux. Over the long term, financial market investing is not a game where the rules are consistent and known in advance.
Risk Management Strategies
Warren Buffet once famously spelled out the two most important rules of investing:
- Rule #1: Don’t lose money.
- Rule #2: Never forget Rule #1.
Notwithstanding Buffet’s assertion, investment risk can never be completely eliminated. But two simple and widely-employed strategies can help mitigate both systematic and non-systematic risk.
- Asset Allocation – Through asset allocation, you decide what percentage of the total portfolio you will invest in each of the four main asset classes – stocks, commodities, bonds and cash equivalents. By including a diverse mix of assets in your portfolio, you are increasing the likelihood that some of your investments will provide reasonable returns even if others remain flat or depreciate in value. Lowering a portfolio’s risk through appropriate asset allocation can lead to greater wealth generation in the long run. This is because a portfolio with diminished risk usually does not decline as much during a market downturn, allowing it to recover more rapidly than a riskier portfolio that has sharply declined.
- Diversification – Diversification involves dividing the money you’ve allocated to a particular asset class among the various sub-categories that exist within that asset class. For example, within the equity landscape, you can choose stocks belonging to the different sectors that exist in an economy. Not putting all your investment eggs in one basket is a time-tested risk management strategy. While you’re likely to feel the jolt of a company that crash lands, it would be much less distressing if that company’s stock is just one among the several others you own.
Hedging (taking an offsetting position in a related security) and insurance are additional tools to manage investment risk. However, both of these strategies may not appeal to certain sections within the investing community because of the extra costs involved.
Your own attitude towards risk is critical. Find out where you belong on the risk scale, and invest accordingly in assets that will help meet your financial goals.