Every investor faces a huge number of unresolved problems in the world of finance. Investment risk management can be identified as one of the key issues. It should be stressed that any and all types of investment entail financial risks. That is why, as early as the stage of investment planning, it is important to assess your potential yield as well as the possibility of partial or complete loss of your funds.
Types of investment risks
There are two main groups of investment risks:
- Systematic Risk is associated with the market and economy as a whole.
- Unsystematic (Commercial) Risk fully depends on the specific investment.
Additionally, investment risks are divided into types according to their origin:
- Political Risk is directly dependent on foreign and domestic policy and exchange rate fluctuations.
- Social Risk has to do with the human factor. Sometimes it is difficult to predict a person’s reaction or behavior as well as the societal context in general, which can negatively affect investment results.
- Technological Risk is inextricably connected with various technological processes, good working condition of equipment at enterprises, and various innovative ideas.
- Legal Risk comes up when existing laws change or new ones get passed, as well as when legal procedures are not independent and objective.
- Economic Risk has a direct connection with tax and financial policy, as well as the economy of a particular country.
There is another large group of risks that arise when buying and selling securities. It is divided into subgroups: macro and micro risks.
Let's start with the macro risks:
- Systemic Risk is directly connected to the market, which affects all financial instruments.
- Sector Risk arises from changes in the economic situation of a particular industry, which can result in an investment loss.
- Regional Risk should be taken into account when purchasing municipal debt securities.
As for micro risks, they depend on a specific exchange instrument or an instrument from a specific issuer.
- Liquidity Risk is a possible partial loss of funds due to the security’s illiquidity.
- Market Risk is a change in the estimated value of securities resulting from certain global events.
- Interest Rate Risk has to do with undesirable changes in interest rates.
How to reduce risks when investing
There are several rules that you can follow in order to significantly reduce investment risk:
- Follow your chosen strategy. In times of high market volatility, follow your initial strategy because a high level of uncertainty can cause the investor to experience cognitive bias that can lead to irrational behavior and ultimately affect the investment’s financial result.
- Pick the investments you understand. You should only invest in those financial instruments you have studied thoroughly.
- Study all the terms and conditions. A contract is one of the most important documents of an investor. Therefore, it is very important to carefully read all its terms and conditions before signing.
- Diversify your investment. This is the golden rule of investing that will allow you to compensate for the loss in some assets with the growth of others. When compiling an investment portfolio, purchase financial instruments that will have uncorrelated dynamics in different economic cycles.
In conclusion, we would like to emphasize that it is practically impossible to reduce risk to zero since any profit above your deposit value is what we call a “risk premium.” However, you can always minimize risk by following the basic investment