Are you a financial risk taker? Do you enjoy an adrenaline kick when it comes to investments? A lot of the population would say no.
Investment is all about risk. If you understand risk in its different forms, as an investor you will be better able to understand how to choose your opportunities to suit your personal level of risk tolerance and which strategies to implement to minimize risk. Get comfortable with risk management and heighten your success.
So let’s take a look at what investment risk is, what some of the different risks are, and how they can be managed.
Definition: Investment risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.
Description: Stating simply, it is a measure of the level of uncertainty of achieving the returns as per the expectations of the investor. It is the extent of unexpected results to be realized.
Investments are tied to various factors. There is never a clean absolute track. Many known and unknown variables play into the balance of risk and return and the outcome. For example, the financial situation of the economy, market, or specific business can fluctuate and effect the gains of an investments. If a country gets hit with tariffs in a trade war for example, businesses can suddenly start to lose sales. Or perhaps there is a massive flood and a railway investment, in the transportation industry, comes to a standstill; a particular industry risk.
These are examples of the two main types of risk; undiversifiable and diversifiable.
Different Types of Risk
1- The first is “systematic” or “un-diversifiable” or “market risk” risk. This form cannot be eliminated; it is to be expected yet the exacts are unknown. It underlies all other investment risk. Examples include inflation rates, the political situation, different forms of war, etc. which are characteristic of an entire market, or market segment.It is about volatility, of uncertainty. It is the everyday fluctuations and how your investment behaves and responds to them. The less risk, the lower the amount of return to be made. The higher the risk, the higher the expected returns. This is where the systematic risk or volatility provides the opportunity to make and lose money in the markets.
2- Known as “unsystematic” or “diversifiable” or “specific” risk is specific to a company, industry, or market. It is financial or business risk based. Spreading your investments across industries, countries, and asset classes that are uncorrelated, known as diversification, is a strategy used to manage this type of risk. Now it may not protect you from loss, but it will keep the overall portfolio in better shape than if you had all your eggs in one basket and that basket got dropped on the floor.
Though there are a great number of risks within each of these two general categories of external forms of risk, keep in mind that the psychology of risk also has an effect on the investment decision making of an individual and the risks that entail.
To be able to assess the risk of an investment is incredibly important before any decisions are taken. Different forms of risk have different forms of management which can increase or decrease the risk in accordance with the investors goals.
How much risk can you take without tossing and turning through the night with a sweat, would be a good indicator of your tolerance level. To start with a person must figure out what their level of risk tolerance is, how much risk they can handle, before undertaking various investments. Each person has their own level of years lived, of anxiety, and financial freedom. Risk tolerance depends on all three.
Your time horizon, when you might need the funds of your investment, plays a role in how much risk you decide to take. On the short run its safer to take less risk and on the long if there is time to play the wait game higher risk can be taken.
The amount of capital you can afford to risk, otherwise known as risk capital, will also help determine your level of risk tolerance. Someone with excess financial stability may not worry about the loss of an investment. With the help of a financial advisor, a consultant, a personalized level of investment risk can be devised.
Risk Management Strategies
Understand that there is risk in every investment. The point of investing is to increase your capitol. When times get tough and you lose capital, you still want to be able to maintain or grow it during the good times. Basically the risk involved should be able to endure if it does go sour. It may sound easier than it might be, but with the help of a few disciplined practices managing risk becomes easier and feels more comfortable.
*Position sizing. How much you are willing to put on different opportunities with varying risk levels. To minimize risk, you could position yourself in safer waters by investing less in a high risk and more on a low risk opportunity for example.
*Diversification. Keep your portfolio wide and diverse in-order to manage how much risk you are exposed to, and to gain overall higher returns. For example, if investments spread across a variety of industries and asset classes, a downturn in one will not affect another unless the two are correlated. This strategy tackles unsystematic risk.
*Valuation. Calculate the value estimation of the investment. Correct numbers, data, and analysis are vital to understanding the risk involved.
*Due diligence. When deciding on an investment, the proper leg work must be done. Research the background, the financial history and management, and all you can in order to know what you are getting into and what potential risks exist. You want to know how to handle what risk there is and set a strategy.
*Loss prevention. Strategies can be put in place to minimize loss instead of work to eliminate a known risk. A common example used is theft. A warehouse filled with product is susceptible to theft and it is hard to eliminate it completely. Putting in place a strong security system however will help reduce loss.
*Exit strategy. Set an exit strategy for how and when to liquidate assets if needed. To have a contingency plan allows for smoother sailing in times of heavy storms. Side note – exit strategies are used for many reasons – not just risk management.
Professional investors understand that investments come with risk. Individual investors will have different views and level of risk tolerance than someone who does it professionally, yet the risks are the same. By understanding what risks are involved and what risk management options are available, risk management becomes an easier process with much to gain from.