Are There risk in investment? Who among us doesn’t tremble at the thought of putting our money into the stock market or some other types of financial asset . Worry about the possibility Benjamin Graham, the “father of value investing,” is a name that is likely familiar to you. He added, “The secret to generating money in the stock market is managing risk, not avoiding it.” Yes! Investment risk is inevitable, but it can be mitigated by careful planning. You must be thinking at this point how we ought to handle potential risk. As we often say, though, don’t worry! We hope that by working together we can help you better comprehend financial concepts. Let us now understand what is an investment risk management with examples in this topic.
Everything that deals with money has some element of risk management. This occurs when a buyer of bonds opts for U.S. Treasurys instead of corporate bonds, when a fund manager hedges against currency fluctuations by purchasing currency derivatives, and when a bank performs a credit check before extending a consumer loan. To mitigate or manage risk, brokers use derivatives such as options and futures, while asset allocators and portfolio managers employ a variety of investment management and risk management tools.
What is an Investment Risk Management?
Finding, assessing, and prioritizing risks is what investment risk management entails. The next step is the strategic and efficient use of resources to mitigate adverse outcomes, keep tabs on positive developments, and maximize the former.
The term “investment risk management” is commonly used in the financial sector to refer to the steps taken to identify, evaluate, and either accept or lessen the potential negative outcomes of investment choices. For the sake of a fund’s investment objectives and risk tolerance, risk management entails an investor or fund manager analyzing and trying to quantify the possibility for losses in an investment. Such as a moral hazard, and then taking the appropriate action (or inaction).
You can’t separate risk from reward. Although the risk of investing in U.S. Treasury Bills is nearly negligible, investing in equities in emerging countries or real estate in regions with strong inflation has much higher risks. There are a variety of ways to quantify risk. Knowing the ins and outs of various forms of risk is helpful for investors in weighing the benefits, drawbacks, and overall costs of various investing methods.
How Investment Risk Management Works
The word “risk” typically evokes negative connotations. However, in the realm of investment, risk is inseparable with successful outcomes. The term “investment risk” refers to the potential for negative outcomes compared to pre-set expectations. We can quantify this discrepancy or place it in context by comparing it to an established standard or market average.
Most financial experts think that a non-zero difference indicates that your investments are progressing in the right direction. Therefore, you should anticipate taking on greater risk if you want to generate more money. Most people also believe that greater volatility follows greater risk. Professional investors seek, and occasionally succeed in finding, measures to mitigate this risk. However, they disagree on the most effective strategy.
An investor’s risk tolerance, or an advisor’s risk tolerance, is determined by the investor’s or advisor’s personal investing objectives. One of the most used absolute risk measurements is the standard deviation, a statistical measure of how dispersed things are around a central trend. It is possible to estimate an investment’s standard deviation by first calculating its average return and then averaging the standard deviation over the same time period.
According to normal distributions, such as the well-known bell-shaped curve. The average return on an investment is only 67 percent of the time expected to deviate by one standard deviation, and only 95 percent of the time expected to deviate by two standard deviations. This aids investors in assessing the level of risk involved. They invest if they are comfortable with the potential financial and emotional consequences.
Example of Investment Risk Management
The S&P 500, for instance, returned 10.7% year on average between August 1, 1992 and July 31, 2007. This figure reveals what occurred overall, but it conceals any developments that were place in the interim. The S&P 500’s average standard deviation was 13.5% throughout the same period. At most periods over the 15-year period, this represents the difference between the average return and the true return.
If you employ a bell curve model, your data should fall within one standard deviation of the mean around 67% of the time and within two standard deviations approximately 95% of the time. For 67% of the time throughout this period, an investor in the S&P 500 might expect a return of 10.7%, plus or minus the standard deviation of 13.5%. For the other 95% of the time, he might anticipate a gain or drop of 27% (two standard deviations). If he has the capital to lose, then he invests.
Investment Risk Mitigation Strategies
Strategies for managing risks are methods for coping with potential adverse outcomes and developing contingency plans. These methods are essential to any risk management programme. An organization or group can benefit from having a define strategy outlining how they will identify and respond to emerging threats using a risk management plan. Let’s take a closer look at the methods available for reducing the potential for loss in our investments.
Maintain Adequate Liquidity
Beware! An unexpected expense can arise at any time. Because of this, we must realize our investments at any time, regardless of the state of the market. Having a healthy cash reserve will help mitigate this threat.
Having access to liquid assets in our portfolio will allow us to make the most of any market corrections that may occur and ensure the best possible long-term returns from our current investments.
When planning your portfolio, it’s a good idea to have enough money set aside for unexpected expenses to last you at least six to eight months. In case of an unexpected expense, we should have access to cash quickly and easily.
For this reason, it is important to have low-risk investing options, such as Liquid Funds and Overnight Funds, in our accounts. Once we have determined our tolerance for risk and established a cash reserve, we may select an appropriate asset allocation strategy.
Know your Risk Tolerance
An investor’s risk tolerance indicates the percentage of potential loss that they are willing to take. One’s risk tolerance is mostly determined by one’s age and current financial situation. Investors in their late 50s who are married and have college-aged children are less likely to take risks than would be the case if the investor were in their mid-20s, unmarried, and had few financial obligations. Therefore, younger investors are more likely to take risks than their more senior counterparts.
Therefore, if we start investing at a young age, we can begin with a portfolio consisting entirely of equities, with the primary goal being to generate income as soon as possible. But those who are nearing retirement and are concerned with maintaining a comfortable financial cushion should avoid this strategy. If we know how much risk we can tolerate, we can select investments with an optimal risk-return value.
Invest in Stable Companies
Avoiding liquidity risk is best done by maintaining a position in a high-quality stock or fund. An examination of a debt security’s credit rating can help investors avoid the possibility of a default. Keep in mind that there is always some degree of risk involved with every investment.
In the previous section, we discussed the importance of determining your risk tolerance before making any financial decisions. Investments are a significant part of one’s net worth, so care must be taken to ensure that they do not negatively impact one’s standard of living.
Diversify for Risk
Investing across the same asset class is a great way to reduce portfolio risk once we’ve settled on the proper asset allocation. Therefore, if we are going to invest in Equity Mutual Funds, we need diversify our holdings across large-cap, mid-cap, and small-cap Equity Mutual Funds.
Small-cap company prices tend to decline more precipitously than large-cap company prices during market downturns. Therefore, diversifying our holdings will reduce our portfolio’s total risk.
Monitor your Investments
After considering these factors, it’s important to maintain a watch on one’s portfolio. Long-term investors shouldn’t simply stash their cash and hope for the best. Check up on your portfolio’s progress on a regular basis to make sure everything is still on track.
Because stocks and other investments can see significant short-term swings, it’s important to review your portfolio at least once every six months. If you are investing for the long haul, you should disregard short-term volatility and only make adjustments if your investments perform poorly over a prolonged period of time.
If you do this, your investments will continue to grow, bringing you closer to achieving your financial goals. Successful investment is about investment risk management, not risk aversion, as we stated at the outset of this blog. We really hope you got something out of this blog and that you’ll put the advice here to good use in the real world. Help us achieve our mission of making people more financially literate by sharing this blog with those you care about.