Working in the financial markets is to some extent associated with risk. This factor cannot be completely excluded, but it can be minimized. And for this it is necessary to determine what investment risks are and what is their source.
Concept and types of investment risks
Investment risks are the likelihood of losses, partial or complete loss of your deposit when investing in financial instruments. As a rule, the level of risk is directly proportional to the potential return on investment instruments. In other words, the higher the profitability, the greater the risks. However, the risks are not always directly related to specific instruments. There are several classifications of risks. The most common is their division into systematic and non-systematic risks. Systemic risks, or, as they are also called, non-diversifiable, are risks that are associated with external factors and apply to the entire market as a whole. These include:
- Market risks. These are the risks associated directly with changes in the value of assets. If price fluctuations are not too significant, then such an asset is considered quite stable. And if it is subject to strong volatility due to the slightest changes in the market, then it is quite difficult to predict its behaviour. Therefore, it is risky to acquire such assets.
- Currency risks. They are associated with changes in the exchange rate. When purchasing foreign currency, there is always a risk that its rate will begin to decline relative to the national one, and the investor will incur losses.
- Risks of a change in the bank rate. The bank rate is the main instrument of monetary policy, which is the interest rate at which the state bank issues loans to commercial banks. The cut in the bank rate will boost manufacturing activity and boost money turnover. Accordingly, during this period it is most profitable to purchase securities. An increase in the key rate has the opposite effect.
- Inflationary risk. This type of risk is associated with rising inflation and the depreciation of money. As inflation rises, the level of income for investors decreases.
- Risks related to asset liquidity. The more liquid an asset is, the easier and faster it can be sold. The illiquidity of assets can prevent their profitable sale at the most appropriate moment in time. Deals with low-liquid assets may drag on for a long period, which may negatively affect the investor’s strategy.
- Random risks. These are risks arising from unforeseen events, which, as a rule, are global in nature. For example, natural disasters, political conflicts, social unrest, etc. All these factors can have a significant impact on the market, and, accordingly, on the level of investment income.
The second type of risk identified by specialists is a non-systemic risk. They are also called diversified. They are associated with a specific industry, investment instrument, or even an issuer. Therefore, due to proper diversification, such risks can be minimized. The main non-systemic risks include:
- Business risks. These are the risks associated with the poor quality of the company’s management. The adoption of ineffective management decisions can lead to a decrease in sales turnover, an increase in profits, and as a result – a decrease in the value of the company’s shares.
- Operating risks. Such risks arise in the process of transactions with assets, both by the investors themselves and by intermediaries such as banks or brokers. Erroneous or even fraudulent actions on the part of such unscrupulous intermediaries lead to losses for the investor.
- Financial risks. This is a type of risk associated with the issuer’s financial condition. The deterioration in the financial condition of the company can affect its ability to fulfil obligations to the investor. For example, holders of dividend stocks run the risk of being left without dividend payments in the event of an increase in the issuer’s debt burden or a decrease in the growth of its income.
Investment risk assessment
Investment risks are assessed using various methods. The main ones include:
- Method of analogies. The risk assessment takes into account the experience of investing in similar conditions. How expedient were the investments, and what effect did they bring?
- the Delphi method. The Delphi method is a method of expert judgment. By studying the opinions of experts and their forecasts, you can get more reliable data than with independent analysis on your own.
- Analysis of statistical data. The study of statistical indicators allows you to analyze the dynamics of the value of assets over a certain period of time and predict a further trend.
If the investor does not have enough experience, then there is a possibility that he or she will not be able to correctly assess the risks. Therefore, it makes sense to turn to professional investment advisors. Typically, these services are provided by investment companies, brokers, private financial advisors or even investment marketplaces like Bristol House Corporation (BHC) or Sheer Markets. Experts will help to determine the investor’s risk profile, and in accordance with this, they will select assets with a suitable level of risk.
How to minimize risks
As it was already mentioned, there is no way to completely eliminate the risk when working in the financial markets. However, it is possible to minimize them. This can be done in several ways. Let’s consider the main ones:
- Diversify. Diversification means compiling an investment portfolio in such a way that the assets included in it have a weak correlation. In other words, a change in the value of some assets should not affect the value of others. A well-diversified investment portfolio is less prone to volatility and drawdown. There are several ways to diversify the instruments included in the portfolio. The main one is diversification by asset class. It is recommended to include in the investment portfolio different types of instruments that behave differently under equal conditions. It is likely that in the event of a fall in the value of some assets, this will be offset by an increase in the price of others. Also, diversification by sectors of the economy will not be superfluous. Acquiring shares, for example, exclusively in the oil and gas industry or mining, is not very rational. The need for sectoral diversification was clearly demonstrated by the situation associated with the pandemic. While some industries were in stagnation and even fell, others were actively developing. The winners were those investors who had assets belonging to different sectors of the economy in their investment portfolio.
- Rebalance your investment portfolio periodically. Even a well-designed investment portfolio needs rebalancing over time. This is due to the fact that the market situation is constantly changing, and the previously selected ratio of instruments may no longer provide the required level of risk. Therefore, it is necessary to periodically review the composition of the investment portfolio and adjust it, depending on the prevailing conditions.
- Use stop orders. This method of minimizing risks will be more useful for traders than for long-term investors. If you adhere to a short-term strategy and are not ready to wait for securities to rise in price, or are not at all sure that they will rise, it makes sense to place stop-loss orders. This type of order will not allow you to incur too large losses. If the quotes reach the value set by the trader, the assets will be automatically sold. This will limit potential losses.
- Invest in understandable instruments. It is quite risky to invest in instruments that you have no idea about. Choosing an unfamiliar industry or tools that you don’t understand in principle can incorrectly assess the possible effect and level of risk. It will be helpful to have knowledge of the investment option you choose.
Investment risks are the potential for losing all or part of the invested funds. Investment risks can spread both to the market as a whole and to individual companies. It is impossible to completely eliminate risks in the investment process, but there are ways to minimize them. The main ones include diversification, portfolio rebalancing and the use of stop orders.