Many people understand risk management intuitively, as minimising risk is an integral part of survival. Whether you are looking both ways to assess the risk of incoming traffic, sharing your live location on a trip or buying a screen guard for your phone. What you are doing is identifying, assessing, and taking steps to mitigate potential risks associated with everyday decisions. In investing, risk management takes on a very similar form as Investors navigate financial markets by identifying potential threats, evaluating their impact, and implementing strategies to mitigate risks. In this write-up, we discuss the concept of risk management in investing and tools for managing investment risk.
Risk and investing – Two sides of the same coin
Every investment involves some degree of risk. Whether you’re investing in stocks, bonds, real estate, or any other asset class, there’s always the potential for loss. This is because the very act of investing is simply taking on an accepted level of risk with the expectation of a reward. For example, in the case of fixed-income investing, you are lending money to a borrower (opening yourself up to default risk) with the expectation that at a future date, the borrower will repay you back your money with interest. In stock investing, you are accepting the risk of a loss in your capital (capital risk) with the hopes that the company will be worth more in the future.
This risk perspective to understanding investing explains the very popular risk-return tradeoff which states that higher levels of risk should be associated with higher levels of returns. From the perspective of a risk taker (read investor), this makes sense because the only reason to accept higher risk is the promise of a higher return.
Not all risks are created equally
From the above analogy, you might be tempted to think that default risk or capital risk is the only form of risk that an investor is faced with. However, Investment risk has various forms and recognizing the various forms is an important step in risk management. Here are some of the key types of investment risk.
Market Risk (systemic risk)
Market risk, refers to the risk of loss due to factors that affect the overall performance of the financial markets. This includes factors such as economic downturns, political instability, and market volatility. You can protect yourself from market risk to some degree by having investments across different markets.
Credit Risk (default risk)
Credit risk is the risk that a borrower will fail to repay a loan or debt obligation. This risk is particularly relevant for fixed-income investments such as bonds or loans. Factors that contribute to credit risk include the financial health of the borrower, changes in credit ratings, and economic conditions.
Inflation Risk
This refers to the risk that the purchasing power of your investments will decrease over time. Investments with fixed returns, such as bonds or savings account with low interest rates, are particularly vulnerable to inflation risk.
Liquidity Risk
This refers to the risk that an investment cannot be quickly sold or converted into cash without a significant loss. Investments in illiquid assets, such as real estate or private equity, may be more susceptible to liquidity risk, especially during periods of market stress.
Currency Risk (Exchange Rate Risk)
This arises from fluctuations in the value of foreign currencies relative to your home currency. This risk affects your purchasing power for foreign and imported goods. In Nigeria, where most goods are imported, it is one of the largest contributors to the inflation currently being witnessed. It can also impact Investments denominated in foreign currencies when converting profits back into your home currency.
How do you manage these risks?
Step 1: Understand your Risk tolerance and risk appetite
The very first step to solving a problem is to understand the problem. To manage investment risk appropriately, the first step is to understand your risk tolerance and appetite. Risk tolerance refers to your ability to withstand fluctuations in the value of your investments without experiencing undue stress. It’s a measure of your financial resilience and psychological comfort level when faced with market volatility. Factors such as your investment goals, time horizon and financial situation all play a role in determining your risk tolerance.
For example, someone with a long-term investment horizon and a stable financial situation may have a higher risk tolerance. This high tolerance level allows them to invest more aggressively in assets with higher potential returns but also higher volatility. On the other hand, someone nearing retirement is likely ot have a lower tolerance for financial uncertainty and may opt for a more conservative investment approach to minimize the risk of capital loss.
Risk appetite, on the other hand, refers to your willingness to take on risk in pursuit of investment returns. It’s more subjective and psychological than risk tolerance and reflects your attitudes, beliefs, and preferences regarding investment risk. While risk tolerance focuses on your ability to handle risk, risk appetite focuses on your willingness to embrace it.
Your investment experience, personality traits, and overall investment philosophy can influence your risk appetite. Some investors may have a high-risk appetite, eagerly seeking out high returns even if it means accepting greater uncertainty. In contrast, others may have a more conservative appetite, preferring stability and capital preservation over the pursuit of higher returns.
Typically, your risk tolerance is typically considered more crucial than your risk appetite. This is because it reflects your ability to stay invested during market downturns without abandoning your financial plan. Your risk appetite, on the other hand, guides your investment choices within the boundaries of your risk tolerance. Knowing whether you are a conservative, moderate or aggressive investor and aligning your investment strategy accordingly is key to building a portfolio that meets your financial objectives while managing risk effectively.
Step 2: Understand your behavioral biases
Behavioural biases play a significant role in risk management, as human emotions and biases can influence decision-making and risk perception. Individuals perceive and assess risk differently based on their experiences, beliefs, and emotions. For example, people also tend to feel the pain of losses more acutely than the pleasure of gains, a phenomenon known as loss aversion. This can lead to risk-averse behaviour, where individuals prioritize avoiding losses over maximizing gains. In risk management, it’s essential to recognize and manage loss aversion to avoid overly conservative decision-making. Overconfidence and Herd mentality are also ways in which emotions and behaviour can influence investment outcomes.
Understanding and addressing these behavioural aspects of risk management is essential for developing effective risk management strategies and promoting rational decision-making in the face of uncertainty. By acknowledging and managing behavioural biases, you can enhance your ability to identify, assess, and mitigate risks effectively.
Step 3: Knowing your tools
Protecting yourself from investment risk involves implementing strategies that aim to mitigate the impact of different classes of risk on your investment portfolio. Some strategies that work to protect your portfolio against inflation might not necessarily work for protection against market risk. Some of the risk mitigation tools available are:
- Stop-loss orders: A stop-loss order is a strategy used in minimising losses on financial assets. It is an instruction given by an investor to sell a security when it reaches a specified price level. The purpose of a stop-loss order is to limit potential losses by triggering a sale if the price of the security falls below a certain threshold. For example, suppose an investor purchases shares of a stock at N50 per share. They might place a stop-loss order at N45 per share. If the market price of the stock falls to N45 or below, the stop-loss order will automatically trigger the broker to sell the shares at that price.
- Limit orders: Limit orders allow investors to specify the maximum price they are willing to pay for a security or the minimum price they are willing to accept when selling. This helps control transaction costs and minimize the impact of sudden price movements. By setting a specific price at which they are willing to buy or sell a security, you can ensure that your trades are executed only at favourable prices. Limit orders are effective risk management tools that protect investors from adverse price movements which can occur in equity and real estate investment. They can also help mitigate against emotional decision-making.
- Active portfolio monitoring: Active portfolio monitoring helps investors stay informed about market developments and make timely adjustments to their investment positions. This proactive approach can help them respond quickly to changing market conditions and mitigate potential risks.
- Hedging strategy and options: Investors can use hedging strategies to offset potential losses in their portfolios. This could involve purchasing options contracts, futures contracts, or other derivative instruments to protect against downside risk. Options contracts give the holder the right, but not the obligation, to buy or sell a specified asset at a predetermined price (strike price) within a set period (expiration date). Call options give the holder the right to buy the asset. On the flip side, put options give the holder the right to sell the asset. The owner of a real estate investment could buy put options on their assets with an agreed strike price in the future to protect against both liquidity risk, market risk, and downside risk.
- Credit Insurance: This is a tool to protect investors in the fixed-income market. Lenders can purchase credit insurance to protect against losses resulting from borrower defaults. Credit insurance policies reimburse lenders for a portion of the outstanding loan balance in the event of default, reducing the impact of credit losses on the investor.
- Diversification: Diversification is an investment strategy that involves spreading your investments across a variety of different assets within a portfolio. The goal of diversification is to reduce risk by investing in assets that are not closely correlated with each other. By diversifying, investors can potentially minimize the impact of adverse events affecting any single investment or asset class. Investors can also diversify across different markets to protect themselves from market risk.
- Dollar-cost averaging: Dollar-cost averaging (DCA) is an investment strategy that involves investing a fixed amount of money at regular intervals, regardless of market conditions. making it easier to manage how much you invest over time amid market volatility. This can reduce the risk of investing a large sum of money at a single, potentially unfavourable, point in time. By investing regularly over time, investors can also take advantage of compounding and potentially achieve better long-term returns.
Employing risk management tools and strategies tailored to specific risk profiles can enhance the effectiveness of risk mitigation efforts. Stop-loss orders, limit orders, active portfolio monitoring, diversification, and dollar-cost averaging are just a few examples of risk management tools that you can utilize to navigate financial markets with confidence. Ultimately, by integrating risk management principles and strategies into your investment, you can better safeguard your investments. In an ever-changing and unpredictable world, proactive risk management is a cornerstone of successful investing and financial well-being.
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