What are investment risks and how to properly manage them?
When choosing investments, many novice investors first of all pay attention to profitability – the higher it is, the more attractive the option of placing money seems. But it is important to remember a simple rule: return is always directly proportional to risk. The higher the promised interest, the higher the probability of losing money. It is almost impossible to completely avoid investment risks, but you can learn how to minimize them. We will cover the main risk management methods in this article.
What are the risks for private investors?
The situation on the stock market depends on many factors — from the state of the global economy to the current news agenda. Unpredictability is the main source of risks that all investors have to reckon with.
Investment risks can be divided into macro-risks and micro-risks. The former are related to macroeconomic or political factors, while the latter are related to specific issuers or exchange-traded instruments.
Macro risks include:
- Systemic risk is the risk that extends to the entire market as a whole and affects all financial instruments. For example, the risk of default or the fall of the country’s economy as a whole.
- Regional risk is the probability of deterioration of the economic situation in a particular region. This risk is especially important to consider for owners of municipal bonds, as well as shares of city-forming enterprises.
- Industry risk – the risk of an unfavorable situation in a particular industry. For example, as a result of the coronavirus pandemic, companies operating in the oil, aviation, tourism and other industries have come under pressure. The owners of their shares faced a drop in quotations.
The group of micro-risks includes:
- Liquidity risk is the inability to sell an investment instrument quickly and without significant losses. It occurs due to low demand for an asset or a large difference between the buying and selling rate.
- Credit risk – implies the loss of money due to the insolvency of the issuer. Both bondholders and equity holders are exposed to this risk – if the issuing company goes bankrupt, they may be left with nothing.
- Exchange risk is the danger of losses from exchange transactions due to an unfavorable change in the price of an asset.
Separately, it is worth highlighting the so-called monetary risks – they are inherent not only in investments, but also in any other financial transactions. This group usually includes inflation, currency and interest rate risks:
- Inflation risk is the risk that inflation will exceed the return on your investment portfolio.
- Currency risk is the possibility of losing money due to adverse fluctuations in foreign exchange rates. For example, if you keep all your savings in USD, the main risk factor will be the depreciation of the national currency.
- Interest rate risk is the risk of loss due to adverse changes in interest rates. At the same time, both an increase and a decrease in rates can lead to losses – it all depends on the specifics of the transaction.
Depending on the cause of occurrence, risks can also be economic, political, technological, social, legal.
How to manage investment risks
In investments, it is important to clearly understand exactly what risks you expose your capital to by investing in a particular instrument, as well as correctly assess potential losses and, if possible, reduce them. Here are some ways to reduce investment risk:
- Diversify your investments. To protect the portfolio from sharp drawdowns, it should be diversified wisely. Distribute savings among several instruments – stocks, bonds, deposits, mutual funds. The more diverse the assets, the less likely that the fall of one of them will hit the entire portfolio. And so that your capital does not depend on the situation in a particular industry, it is advisable to invest in companies from different areas. When some areas are in decline, others are actively growing, which is clearly demonstrated by the current crisis. Another important rule of diversification is the distribution of money between countries and currencies. Geographical diversification reduces the exposure of the portfolio to political and economic issues in a particular country, while currency distribution protects against exchange rate fluctuations.
- Use stop loss orders. If you practice short-term investments, this tool can be very useful. A stop loss is an instruction to a broker to automatically sell securities if their quotes drop to a certain value. This allows you to limit losses to an acceptable level. For example, you bought shares at $25 a share, and they began to fall sharply in price. It is unacceptable for you to drop securities by more than $5. So you should set a stop loss at $20 per security. If the shares fall to this value, they will be sold.
- Always follow the chosen strategy. If you invest for the long term, you will surely encounter market corrections. In this situation, it is important to restrain emotions and continue to follow the initially chosen strategy. It is important to remember that panic and rushing from one asset to another bring more losses than gains in the end, and in the long run, the stock market rises.
- Pay attention to the risk level of financial products. Some investment instruments have a predetermined level of risk. For example, ETFs traded on the Moscow Exchange are marked on a scale from 1 to 7, where 1 is the most reliable and 7 is the most risky fund. With the help of this marking it is impossible to assess the absolute size of the risk, but it is possible to compare different tools and choose the most suitable one.
- Invest in understandable tools. If you do not understand how an asset works, it is better to abandon it or study it carefully before investing money.
- Rebalance your portfolio regularly. Over time, the ratio of assets in a portfolio may change, making it more conservative or risky. To maintain an optimal level of investment risk, it is sometimes necessary to rebalance the portfolio, that is, bring the percentage of assets to the original values.
How to know what level of risk is right for you
Before you start investing, decide on your goals. The level of risk acceptable to you will largely depend on them. For example, if you are under 30 and want to save up for a comfortable old age, you can take a chance and invest in stocks. In case of failure, you will have time to compensate for losses using conservative tools. If you are over 50, stocks become too risky for you, and you should give preference to more reliable investments.
The easiest way to determine your attitude to risk is to take risk profiling with a broker. This is a small test consisting of questions about your goals, desired return, acceptable risks and investment horizons. Knowing your risk profile will make it easier for you to choose the right investment vehicles.
What to remember
- Risk-free investment is not possible, but you can keep it under control and even minimize it.
- There are several ways to reduce risk, among them – diversifying investments, following the chosen strategy, using stop orders, rebalancing the portfolio in a timely manner.
- To understand what level of risk is acceptable for you, determine the goals and terms of investment, and also go through risk profiling with a broker.