When you start out in the world of finance, the expression “risk management” is a widely used term. Although it may seem easy to understand, it contains a large amount of information essential to successful financial investments. What is the real role of risk in investing? And how to limit its effects?
In daily life, we naturally manage risks . We take out health insurance, in order to be protected in the event of illness. And we wear a helmet when we ride our bike, to avoid a serious accident. This notion of risk management also applies to financial markets.
Investment risk management is a crucial area to study for investors who want to grow their portfolio. To do this, they have several tools at their disposal, which allow them to better understand the world of the stock market.
What is risk management in finance?
The notion of risk in finance represents a danger: that of losing money when taking part in an operation or purchasing an asset. Risk is omnipresent in finance, to the point where it is a sector that companies often delegate to one person, the risk manager.
As you can see, risk management is a fairly complex concept, which should not be taken lightly . There are several types of risks in the financial sector:
Market risk , which is the best known. This is the risk inherent in using financial instruments whose prices fluctuate. For example, a currency that falls (this is called currency risk), or a stock that underperforms.
Liquidity risk . This is the risk associated with purchasing an asset in an illiquid market. There is then a risk of not finding a buyer upon resale.
Interest rate risk is simply the risk linked to changes in interest and credit rates. A borrower risks a rate increase, and a lender risks a rate decrease.
Operational risk ; this is a risk of failure of the tools used. For example a broker whose platform is taken offline while you want to sell an asset.
There are other types of risks, but these are the main ones. We will note in passing the risks linked to factors located outside the world of finance. Examples include geopolitical factors and changes in interest rates, or weather conditions. This is why monitoring current events is considered a key factor in financial risk management.
For those in the world of finance, it is important to keep these notions in mind, in order to make informed choices when investing in currencies or stocks. It should also be noted that when we talk about financial risk management, it is not necessarily about reducing risk, since it is always present. This involves taking into account all types of risks linked to a particular transaction: this is the notion of return/risk. And this is particularly important for the stock market, as we will see.
Investors in stock markets need to pay close attention to risk. By nature, an investment in a stock always involves two main risks:
Volatility risk , i.e. the propensity of an asset to experience significant price fluctuations. For example, the euro is considered less volatile than cryptocurrencies .
There are several strategies for managing risk when choosing to invest in stocks . We can first analyze the past performance of a stock . This allows us to determine its average volatility, as well as its growth potential. We will therefore always carry out a risk analysis based on the history of an action. The logical conclusion from all this is that “young” stocks are naturally considered riskier.
Another common strategy to mitigate risk when purchasing stocks is to diversify your portfolio . It simply involves purchasing a variety of assets, in order to spread the risk. In this way, if a stock falls, only part of your capital is involved, the rest being covered by the other stocks.
Let’s also mention the simplest way to mitigate risk on the stock market: invest only the amount you are prepared to lose . If we only put an amount at stake that we can part with, this means that in the event of failure, we will not put our financial security at risk.
The stock market investor is distinguished from the trader by his goal. For him, it is not about making a quick profit, by betting on the rises and falls of a stock in the short term. This long-term choice means that an investor must look more closely at the companies behind these actions, particularly venture capital.
Tip: What will help an investor in the stock markets the most is having a consistent and consistent strategy. This often means choosing buy and sell thresholds, and sticking to them. We cannot in fact analyze the performance of a strategy if we do not stick to it every time.
This type of financial risk management is of course mainly psychological in nature: it is about keeping a cool head, during losses as well as during price increases. It should also be noted that for an investor, hedging is a good way to mitigate risk . This involves taking two positions that are the opposite of each other, with the same amount committed. The risk is thus canceled, but with a consequence: we cannot make significant gains. It is therefore a strategy to be reserved for times of uncertainty in the markets.
For this, the stock market trader has several tools at his disposal. There is of course the “stop loss”, which allows you to close a position as soon as it exceeds a certain threshold. This avoids too sudden falls. Conversely, “take profit” helps mitigate the risk of greed. This closes a position when it reaches a performance threshold, rather than waiting for it to climb further and thus risking a flash market correction.