In the stock market, risk management is critical to protect investments and ensure profitability. Several risks must be managed when investing in stocks, including market, credit, liquidity, and interest rate risk.
What is Risk Management?
Risk management is the process of identifying, assessing, and managing risks to an organization. It includes both the proactive identification of risks that could potentially affect the organization, as well as the development and implementation of plans to address those risks.
PODCAST – Manage Risk or Get Burned… Your Choice
Do you know how to manage risk? Do you consider it as a factor before you invest?
- PublishedSun, 03 Dec 2017 23:00:00 GMT
- Duration: 00:08:15
Types of Financial Risk
There are many different types of financial risks that people and businesses need to be aware of, including:
- Market risk is the risk that the price of a security will fluctuate due to changes in the overall market. Market risk can be mitigated by diversifying one’s portfolio across different sectors and industries.
- Credit risk is the risk that a borrower will default on a loan. Credit risk can be mitigated by investing in high-quality, investment-grade securities.
- Liquidity risk is when an asset cannot be sold quickly enough to avoid losses. Liquidity risk can be mitigated by investing in highly liquid securities.
- Interest rate risk is the risk that the value of a security will decline due to changes in interest rates. Interest rate risk can be mitigated by investing in securities with longer-term maturities.
A Practical Example of Risk Management?
We manage risk every day. Risk management is the process by which we decide what the potential downside of a particular deal is compared to the upside. For example, if your bank loans you $10,000 for a new car and you agree to pay back $10,500 in three years, the bank will make a total gain of 5%. This is the reward.
However, the bank must evaluate if the reward is worth the risk. To do this, they would like to know how much you earn, how much debt you currently have if you own your own house, and if you have ever defaulted on a loan before. They might conclude that there is a 0.5% chance of you failing to repay the loan.
This would mean that for the gain of $500 they are willing to take the risk of the loan defaulting.
The risk of 0.5% compared to the reward of 5% means the bank would have a risk-reward ratio of 1/10. As 0.5% is one-tenth of 5%
It would help if you tried to use this method of assessing risk in your investment. What are the chances of this bond, treasury, stock, or precious metal falling in price or becoming worthless? What will be the expected reward?
It is a common statement in the financial services industry that stocks can go down as well as up. This is also true for all investment categories.
Diversifying Your Investment Portfolio
Diversifying your investments is a good way to achieve long-term balanced growth. Different investment vehicles behave differently at different times. During times of recession or economic hardship, stocks perform badly, and precious metals and treasuries do well.
During boom times, property and stocks outperform metals and bonds. It can serve you well to allocate a proportion of your investments into different asset classes based on time and risk profile.
- Low Risk – Bonds, Treasuries, Bank Account
- Medium Risk – Housing, Property, Mutual Funds, ETFs
- Higher Risk – Individual Stocks
- Highest Risk – Options, Currencies, Commodities, Spread Betting, Contracts for Difference (CFDs)
Your goal in investing can often be determined by the spread of risk as you diversify your investment pot.
We have covered some of the fundamental questions that face you, what type of investor are you, what your goals are, and how to manage risk.
In the next section, we will look at the different types of investments you can make.