Investments carry risks, but we know that we can reduce them.
With a good risk management strategy, you can feel more confident in your financial future.
Beginners can easily grasp the concepts of investment risk. They are easy to understand, and a low-risk portfolio can be made with some extra considerations. But as always, investors are advised to maintain a cool head and not react emotionally to changes.
This is the first step in reducing risk; remembering that risk is always present, but that you can prepare for it with a calm, cool strategy and a generally unemotional approach.
In this article, we will just go over the basic steps for setting up a beginner’s risk management strategy.
What are financial risk management strategies?
A financial risk management strategy is a plan for reducing the inherent risks in any area of finance.
There are a few things that go into risk management:
- Your asset allocation
- The diversity in your portfolio
- Direct measures, such as stop-loss orders
When put together, each of these individual areas adds up to a risk management strategy.
Before you can even get started, you also need to understand your own risk tolerance.
Risk tolerance
Risk tolerance describes your ability to endure the risk of losing your money.
Your risk tolerance will normally be determined by:
- Your age and financial objectives
- Your current financial responsibilities
- Your personal ability to handle stress
In general, finance experts suggest taking more risks while you’re young. But as you’re getting closer to retirement, they will suggest that you take a more conservative approach to saving. This is because you have a longer time until retirement when you’re young, meaning more time to recover from downturns.
Of course, you must always consider your personal limits and beliefs as well. Some people can’t handle a more risky portfolio, as it can lead to rash decision-making when the stress really hits. There’s a good argument to be made for considering your own ability to handle the stress of potentially losing money.
Asset allocation
Asset allocation describes the weight of the asset classes in your portfolio. What mix of the following do you include in your portfolio?
- Stocks
- Bonds
- Cash
- Alternative investments
Of course, each asset class contains its own range of risk. But overall, if you are willing to take more risk, you will invest more in stocks and less in low-risk bonds like treasury bonds, which provide guaranteed principle interest, but can easily be outperformed by wise stock investments.
If you’re particularly open to risk, you may also add some alternative assets to your portfolio.
Within stocks, there is a range of risks present as well. Your approach to selecting stocks will be a part of your risk management strategy.
Portfolio diversification
Portfolio diversification must be considered alongside asset allocation.
Diversification means selecting a range of assets within each asset class. This is done to help you minimize investment risk. Diversification is done by a mix of:
- Asset classes
- Individual assets
- Industries
- More
For example, if you invest in many stocks, but all within the same industry, you will be in trouble if there’s an industry-wide downturn.
Stop-loss orders
Stop-loss orders are placed with brokers to buy or sell a specific stock at a specific price.
In terms of risk management strategy, you can place a stop-loss order to avoid losing too much of your investment. In that way, they are designed to simply minimize loss.
What is an example of a risk management strategy?
Put all together, a risk management strategy looks like this:
- Having multiple asset classes in your portfolio
- Having more individual assets
- Holding stocks from companies in several industries
- Perhaps having only up to 5% of your portfolio in alternative assets
- Using stop-loss orders to minimize the potential risk for your riskier picks
What are the 5 types of financial risks?
There are 5 types of financial risk that any investor should know about. Even beginners should be aware that these risks may come to affect any portfolio.
1. Market risk
Market risk is the risk present due to the changes in the price of a financial instrument. That can mean changes in asset price, interest rates, and more.
These changes are determined by market forces well beyond any individual investor’s control. You can build a greater understanding of market risk to avoid loss, but there is always some risk of market forces causing you a loss.
2. Credit risk
Credit risk is also known as “default risk”.
It is the risk associated with borrowing money. If a borrower is unable to pay back a loan, there is a chance of them defaulting. Creditors may of course see a rise in the cost of recollecting the debt.
For investors, credit risk may come in the form of decreased income from loan repayments. Lower than expected principal and interest rates may result.
3. Liquidity risk
Liquidity risk means an asset cannot be purchased or sold quickly enough to avoid negative consequences (losses).
For investors, this can normally mean one of two things:
- You cannot sell an asset quickly enough to cut your increasing losses, often due to having few buyers, but many other sellers
- Your debt instrument is not paid back because the company is unable to repay its debts and is forced to default
4. Operational risk
Operational risk is the risk of technical failures, managerial incompetence, or other failings that cause investors a loss.
It can also include legal risk, which is often classified as another financial risk category, covering fraud or any operational criminal activity resulting in a loss for investors. Legal risk also covers financial risk to investors resulting from lawsuits costing a company too much money.
5. Model risk
Model risk can also be classified as another type of operational risk.
It specifically refers to the poor application of a financial model, causing a loss for investors.
Conclusions on Having a Good Risk Management Strategy
As you can see, there are many risks in the financial world. That’s why a risk management strategy is so important.
There are a few pillars to a good risk management strategy, and we suggest you apply those that are relevant to your investment strategy.
Beyond that, the only thing you can do is stay up to date with the doings of organizations you invest in. For example, it’s important to learn about a company’s management, and keep up with any developments that may cause any type of risk.
