Any investor would agree that ignorance and lack of awareness in the investment field can prove to be expensive. In the world of finance and investment, risk management is very closely related, rather necessary for measuring performance. Understanding risks is therefore, a crucial part of building your financial and investment knowledge.
Before making any investment, it is common for us to explore the benefits it offers. However, it is all the more important to be aware of the risks involved in the investment. Knowledge of the potential risks, will help us to manage and control the hidden losses that it can cause.
Therefore, a good advice here is a detailed investigation of the investment, before actually jumping into it. Sometimes, this may involve a lot of hard work but down the line, it will surely save you from expensive losses.
1. Understand the Risk Management
Managing risks is an important factor, to lay your focus on before making an investment. We usually have a tendency of considering risk as something negative. Here, we are likely to forget the notable paradox, which suggests that we do not completely understand any investment, till we know all its related means of losing money from it.
In other words, we should identify all the major risks that could lead to probable losses, well in advance. Thereafter, we need to proactively manage all the feasible risks. Let us now have a detailed understanding of the risk management process.
2. Identify the risk profile:
The primary step will involve identification and grouping of the risks, associated with your investment. With a well-designed investment portfolio and strategy, it is possible to manage every critical risk, except for a certain uncontrollable risks.
Let us now study about some specific inherent risks, classified into four major categories.
i. Company-specific: These include anything that is particular only to the company, and is not a part of the industry as a whole. Example of such risks are lawsuits, mismanagement, etc. Such risks can be controlled via diversification.
ii. Industry-specific: These comprise of alterations in the consumer preferences, technologies and industry laws. These can be controlled via not restricting your industry portfolio to any single domain.
iii. Investment Style: These risks may be associated with value vs. growth, or large cap vs. micro cap investments. The market varies with how it manages different investment styles over time. These risks can also be managed by not concentrating on a particular investment style.
iv. Market Risks: These risks are manageable through self-discipline, or by diversification into non-correlated markets such as real-estate, cash & commodities, international equities, etc.
3. Creating a Controlled Risk Profile:
Post understanding the risk profile, you must design ways to control possible risks. In the second place, you must accept only those investments whose unmanaged risk profile does not overlap with other investments of your portfolio. This will result into minimizing the overall risks.
Each investment has its own set of exclusive tools available for risk management. This results from the unique features of the investment and its trading markets. Every market, having its unique characteristics, can thus be utilized for effective risk management. Because what works for one market, may not work for the other.
The symbol of a good investment, is not just achieving strong positive profits, but also consistent and risk-free returns in all market scenarios.
Risk is integral to return. Every investment thus, accompanies some degree of risk with itself. Risk is a quantitative measurement, both in absolute and relative terms. Therefore, a strong understanding of risk and its different forms can surely help investors in better decision-making. This will also help them better comprehend the opportunities, settlements and costs involved in different investment approaches.