What is risk management, and how to use it effectively

There is wealth, and then there is market risk. We crave one and try to avoid the other. But, in many cases, wealth and risk are interconnected. There is no getting to the former without being able to manage the latter. To help you build your wealth, we present this starter kit on risk management. It should help you find ways to deal with investment-related uncertainties better.

What is risk management and risk management process?

Risk management, as the name suggests, refers to how investors identify, analyze, accept, and eventually mitigate risks.

It isn’t about individuals alone. Even huge financial institutions like banks initiate credit checks to issue a loan or credit card and have well-defined risk management strategies. And the process of managing this risk using different strategies and tactics is risk management.

What are the different types of risks that need to be managed?

Every aspect of financial decision-making comes with its share of risks. So whether it is investing in a high beta asset (equities or crypto) or getting hold of relatively safe treasury bonds, it is important to look for strategies that could help you analyze and mitigate the risks involved. Your financial goals should help you identify the type of risks involved in a project and the corresponding management strategies that are best suited for you.

But first, you will need to understand what financial risks are and learn how to identify the different types. Some such risks that require management are:

1. Volatility risk: Your financial portfolio going down significantly within a short period is a volatility risk. A good strategy to manage this risk would include cost averaging investments, doing better research, and only putting in money you can afford to lose.
2. Company risk: For people investing in company-linked equities and cryptos, if a firm you are investing in is unable to generate adequate returns and revenue, that qualifies as company risk. Fundamental analysis is a risk management strategy that works every time with this kind of risk.
3. Opportunity risk: Mostly psychological, an opportunity risk signifies the failure to purchase an asset at a different price than now. Rupee cost averaging is a great way to mitigate this kind of risk.
4. Liquidity risk: When an asset cannot be exchanged (bought or sold) easily, it is said to be hit by liquidity risk. Assets pertaining to nascent markets are prone to experiencing this type of risk.
5. “Sequence of Returns” risk: This form of financial risk affects those who invest in a specific asset after only taking the overall Compound Annual Growth Rate (CAGR) return for a given timeframe into consideration. Many, for example, tend to invest 70% of their money in equity and 30% in debt immediately after retirement. Such people are likely to end up experiencing it the most. If you end up in this position, the Equity Glide Path method is a risk management plan you could adopt to help balance things out. With it, you should keep adding 3% to the equity portion of your portfolio until it reaches 70%.
6. Market risk: People/users moving elsewhere (to different products) is a type of market risk. A reliable management strategy would be for crypto and non-crypto projects to adapt, especially for making services and offerings relevant.
7. Credit risk: The customer failing to pay back on time is a type of credit risk. Stringent credit checks and having sufficient financial reserves are related management strategies that businesses, especially exchanges, employ.

While that’s more or less everything there is to know about the type of risks that need managing, some risks (and the corresponding management strategies) depend on the psychology of the investor involved.

Why is risk management important?

To answer the question in the title above, let’s begin by taking a quick trip down memory lane to the mortgage meltdown in 2007. Back then, lenders had extended housing mortgages to people with subpar credit scores, setting off the great recession. That was an example of what happens when there is no risk management plan in place.

Not having a risk management strategy can be equally or even more detrimental to individual investors. And in a market that’s as bearish as the current one, risk management is crucial.

To break it down, here’s why you should consider risk management:

1. Risk management helps you focus on your financial security.
2. It can be handy when you are trying to ensure that you never run out of money.
3. It helps keep your losses to a minimum.
4. It makes way for a healthier bottom line—that is, your profits exceed your losses.
5. It also offers better visibility of one’s financial future.
6. For businesses, it leads to operational consistency.

What is risk management process

While each person’s risk management needs are unique, there are three broad things you can do to establish a strategy that works for you. Following each of these steps should help equip you to manage your risks better.

Step 1: Accept that some risk is inevitable

First of all, it is important to remember that, in finance, risks are not always a threat. Consider risk as a deviation from the desired outcome and assess how prepared you are if such a situation surfaces. So, if you have a benchmark set, any deviation from the set goal is a risk. The thing to remember is that the deviation can be both positive, meaning you get higher gains or negative. Things could go either way. Accepting this is the first step to healthy investing.

Step 2: Identify how much risk is acceptable to you

The risk you are willing to deal with (which often translates as volatility in the case of financial markets) depends on your risk appetite. A high-risk appetite could open the doors to equities and crypto, whereas moderate and low-risk appetites may mean that you are better off investing in some mutual funds and bonds.

Step 3: Figure out when to cut your losses

Risk management isn’t only about getting you to the good times and gains made on top of the expected value. Instead, risk management is the strategy that could help see you through the dark times—when the negative part of the deviation kicks in. This is where you can take Value at Risk (VAR) into consideration.

VAR is the maximum loss within a given period. Here is a quick way to calculate it:

• First, track the historical data of any asset and maximum loss in a time frame of your choice.
• Calculate how often the asset was in the red. Let’s call this value X
• 100-X is the certainty with which we can say that the losses will get worse in that time frame.

What is Risk Management in Finance?

So far, we have been discussing risk management from a slightly broader perspective. Let’s talk about what it means for you as an individual investor now.

If you are an investor, trader, or even a crypto HODLer, you could use some of the following quick risk management tips.

1. Plan your financial portfolio so that you do not run out of money (a.k.a DNROOM).
2. Strive to ascertain your risk appetite beforehand.
3. Aim for better visibility on your financial future after retirement.
4. Follow the 1% rule (never allocate more than 1% of capital to a single trade).
5. Consider 2% capital allocation if you have a high-risk appetite.
6. Familiarize yourself with moving averages. Adjust the moving average to gain a long-term view of things.
7. Keep an eye on hedging in case the market starts acting up.
8. Learn about take-profit points. That should help you plan your trade exits.
9. Use limit orders and stop losses. They will help you trade better.
10. Remember that your stop-loss figure isn’t etched in stone. You would do well to stay open to changing it, depending on market volatility.
11. Diversify your portfolio.

Wrap-up

If you have your eyes set on a sizable financial corpus, it is important to focus on picking suitable assets. However, every time you go about diversifying your portfolio, either by adding new instruments or increasing the size of a holding, you will need a good risk management strategy. We hope that the discussion above helps, and for daily updates, you could always look at our news section. Happy trading!

FAQs