Every investment has some degree of risk associated with it. You may be afraid of losing your hard-earned money. And keep your money in your bank savings account. In this case, also, your capital is at risk – it will lose its value because of inflation. Before investing money in any financial instrument, you must know the associated risk.
What is a risk?
When you select a financial asset for investment, the decision is based on what you want to achieve from your investment. Risk is any uncertainty with respect to your investments that may negatively affect your financial welfare. In other words, the risk is the possibility that a negative outcome will impact your investment. There are various kinds of risks associated with your investment.
Risk and Reward equation
The risk level associated with a particular investment or asset class is directly proportional to the return level the investment option might give you. The idea behind the relationship is that investors willing to invest in risky investments can potentially lose money and should be rewarded for their risk. It means that reward is nothing but the possibility of higher returns on your investment.
Types of risks
Below are some types of risks every investor must be aware of:
Market Risk – The risk where your investments decline in value because of economic development or other events that affect the entire market is market risk. In equity investment, the market price of shares varies depending on demand and supply governed by economic development in the country or other external events.
Liquidity Risk – The risk of being unable to sell your investment at a fair price and get your money out when you want to is known as liquidity risk. With equity investment, you can sell your investment as and when you need it, but you may have to sell your investment at a lower price.
Business risk – When you invest in a stock, you buy a piece of the company. The returns on your investment largely depend on how the company performs. If the company goes bankrupt and its asset is liquidated, common stockholders are last to get anything from the sale of assets. The risk is known as a business risk, and it is for every company.
Volatility Risk – When you invest in a company, and there is no danger of failing (or the chances are minimum), the stock price may fluctuate up or down. As per historical data, the large-company stocks have lost money, on average, about one out of every three years. For some investors, the sharp fall in the stock price can be disturbing. Hence, you must always invest based on your risk profile.
Horizon risk – The risk that rises because your investment horizon gets shortened because of an unforeseen event is horizon risk. For example, if you lose your job, you will have to sell the investment that otherwise you would have held for the long term. You may have to sell at a lower price if we are in a bear market. To minimize the impact of this risk, you should have emergency funds with you.
Three things you must know about risks
Some investors might avoid risk, while some may take higher risks for more profits. In general, there has to be a balance. You can find the right balance when you understand risk better. Below are some points related to risk every investor must know:
Risk is when you lose money permanently – We have talked about volatility risk above. Volatility, by definition, is not a risk. However, investors sell their investments in a panic because of high volatility. The real risk arises when you lose the money permanently – the company goes bankrupt.
Taking risk is not an option – Risk is necessary as you cannot even protect your capital if you don’t take the risk. Without risk, there is minimal unpredictability and hence minimal profit potential.
Understand your risk capacity – Risk-taking is crucial, but it is not mean that every investor has to take some level of risk. You must understand your risk profile and accordingly invest.
Managing Risk
Based on the above discussion, it is clear that you cannot eliminate risk. However, you can minimize it. There are many ways to minimize your risk. The two things you must definitely do is:
Diversification – It refers to putting your investments over a variety of assets to reduce your portfolio risk. With proper diversification, you are in a better position to withstand ups and downs in the market.
Asset allocation – Under this, you decide how to distribute your investments – you divide your investment based on your investment objectives, investment horizon, asset mix, and current and expected market conditions.
How much risk is enough?
As we mentioned above, taking risks is crucial. However, most investors are unsure how much risk to take. The amount of risk should depend on your financial goals and the time period in which you want to achieve your financial goals. You should also consider your liabilities in mind while investing. The rule of thumb is that the longer your financial goal’s time frame, the higher the risk you can take.
ConclusionFor most investors, figuring out everything related to risk is not easy. Such investors can make use of technology. You can use Jarvis Invest for your investments. It is an AI-driven tool that helps you create an equity portfolio based on your risk profile and investment horizon. Also, it has a risk management system to reduce your risk and maximize your returns.