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Whether you are a professional asset manager or a novice investor, risk managing your assets is equally important. Not all of us have access to specialised risk management software but there is a lot of information available, much of it for free. Every savvy investor must try to quantify the risk attaching to their assets to ensure they meet their risk appetite and investment goals.
What is risk?
Financial risk refers to the chance of losing some or all of your capital invested in a particular asset. This term is used very broadly and the main types of financial risk are as follows:
- Market risk – This type of risk is also known as volatility and encompasses the constant fluctuations in stock prices, foreign exchange rates, interest rates and commodity prices. Volatility is essential in a market as it is these price movements that enable investors to make a profit (or a loss).
- Credit risk – This describes the situation where a borrower fails to make payments as promised and is also known as default risk. This type of risk is of particular concern to those with bond investments and it is possible for an investor to lose all of his or her investment capital and interest.
- Foreign exchange risk – If you hold any foreign investments, you will be exposed to fluctuations in the exchange rate between the two currencies. This means that even if you make a profit on shares in a foreign company, you could still make an overall loss on your investment due to unfavorable changes in the exchange rate.
- Country risk – This is another type of risk that has been in the headlines recently, with Greece defaulting on its financial obligations. War and civil unrest are also a risk, especially in less stable countries. When a country is in crisis, all of the financial instruments and investments held within that country will be adversely affected.
- Operational risk – Operational risk encompasses an institution’s internal reputational, legal and I.T. risks. If there is a failure within a company then the reputation of the firm could be irreparably damaged. This will have a dramatic effect on share prices. We have recently seen a number of well-known financial institutions struggle with reputational risk after catastrophic I.T. failures and general bad management of the firm’s assets.
What is your risk appetite?
Risk cannot be avoided altogether and, without market fluctuations, there would be no opportunity to make a profit on your investments. The key is determining how much risk is right for you.
The general rule of thumb is that the further you are from retirement, the more risk you can afford to take on. You should aim to start out as an aggressive investor, holding a greater proportion of high risk investments such as stocks and shares. As you approach retirement you should invest more conservatively, with a portfolio consisting of mainly lower risk investments such as government bonds.
This is because with a volatile, high risk investment, you are more likely to make a profit if you can afford to hold onto the asset over a long period of time. The financial markets constantly move up and down and you want to sell the asset when it will yield the most profit for you. As you near retirement, you shouldn’t allocate as many high risk investments to your portfolio as there may not be enough time to recoup any losses. You should carry out regular portfolio risk analysis to ensure that you achieve your investment goals.
The risk appetite of an individual varies from person to person. It is a personal preference. Some like to play it safe while some like to play with fire. What is your risk appetite?
How can you avoid risk?
- Avoiding risk by diversification – The best way of ensuring you only take on the desired amount of risk is to diversify your portfolio. Whilst some of your assets may make a loss, the hope is that this loss will be mitigated by your overall investment portfolio. You could diversify in a number of ways, such as investing in different types of assets, held in a variety of geographical locations. The main aim is to ensure that your assets are subject to different kinds of financial risk so that one adverse event will not affect your whole portfolio.
- Avoiding risk by hedging – The other way to limit your risk exposure is by hedging, although this will generally be used by professional asset managers rather than amateur investors. To hedge a trade, a financial institution will purchase an option to offset the original investment and guarantee a certain price should the option be exercised. If the original investment does not perform as well as expected, the investor can choose to exercise the option at a fixed price, thus mitigating their loss.
Taking risks can cause you money, but it can also cause you and your business huge returns. The important thing to remember is to weigh your options first before plunging into the unknown.