What does an investor need to know about risks
Receiving potential profit is directly related to the risk of potential losses. Starting working with assets, each investor first of all acquires risks related to financial intermediaries. The most grandiose example of the collapse of a financial intermediary is the bankruptcy of Lehman Brothers. Today we will consider the main investment risks that everyone who comes to the securities market should know about.
Each financial intermediary, whether a broker or a bank, may face its own market risk, which is the possibility of negative changes in the value of assets as a result of fluctuations in interest rates, exchange rates, share and bond prices, etc.
When the possibility of a negative change in the value of assets may arise from the inability of counterparties to meet their obligations. For example, for interest and principal payments in accordance with the terms and conditions of the loan agreement.
Losses caused by the inability to buy or sell the asset in the right amount in a short period of time due to deteriorating market conditions. Or when a financial intermediary is short of cash or other highly liquid assets to meet its obligations to counterparties.
Occurrence of technical errors in operations, emergencies, personnel errors, etc.
Business risk .
Losses due to force majeure – changes in legislation of actions of state bodies, etc.
You have chosen a financial intermediary, concluded a contract and started operations. What is the risk?
First of all, in the probability of not receiving the expected income from your portfolio.
Or even worse – the possibility of full or partial loss of invested funds and expected income.
PORTFOLIO RISKS: CLASSIFICATION
Risks associated with the formation and management of the securities portfolio are classified into two types: systematic (non-diversifiable) risk and non-systematic (diversified) risk.
Risk related to market reasons: macroeconomic situation in the country or level of business activity in financial markets. This risk is not related to any particular security, but determines the overall risk for the entire range of investments in stock instruments.
SYSTEMATIC RISK CANNOT BE REDUCED THROUGH DIVERSIFICATION,
AND IT DEPENDS ON LEGISLATIVE CHANGES IN TAX AND CURRENCY.
When analyzing the impact of systematic risk, the investor should assess the very need to invest in a portfolio in terms of existing alternatives for investing their funds.
The risk associated with a particular security. It can be mitigated through diversification, which is why it is called diversified.
Selective risk is the risk of wrong choice of securities due to inadequate evaluation of investment qualities of a particular security.
Temporary risk is associated with the late purchase or sale of a security.
Liquidity risk – occurs due to difficulties in selling securities of the portfolio at an adequate price.
Credit risk – is inherent to debt securities and is caused by the probability that the issuer is unable to meet its obligations to pay interest and debt principal.
Withdrawal risk – is associated with possible terms of bonds issue, when the issuer has the right to withdraw (repurchase) bonds from their owners before maturity. The necessity of withdrawal is provided in case of sharp decrease of interest rate level.
Issue risk – depends on the financial condition of the issuer of securities included in the portfolio. The level of this risk is influenced by the investment policy of the issuer, as well as the level of management, the state of the industry as a whole.
Inflation risk – the decrease in purchasing power of the ruble leads to a drop in incentives for investment.
Interest risk is the risk of losses due to changes in interest rates in the market. It especially affects securities with fixed income (bonds), the price and total income of which depend on interest rate fluctuations.
Political risk is the risk of financial loss due to political instability or imposed sanctions.
Currency risk is the risk associated with investments in foreign currency securities due to changes in foreign exchange rates.
HOW TO REDUCE RISK
Methods of reducing the risk of investing in a securities portfolio can be divided into the following groups:
Methods based on the possibility to avoid unreasonable risk.
It means that an investor rejects excessively risky securities, prefers a passive method of portfolio management, tries to interact with reliable financial intermediaries and counterparties.
Methods of risk redistribution.
They allow risk distribution over time as well as portfolio diversification.
Methods of risk compensation.
Insurance of risk and its hedging. Insurance means preliminary reservation of resources by distributing responsibility among a large number of economic counterparties or investment objects in order to compensate for damage from expected manifestation of various risks. Hedging means reducing or completely eliminating the risk of financial losses by entering into a balancing transaction to transfer the risk of adverse price changes to other risk participants. As in the case of insurance, hedging requires the use of additional funds.
Remember, competent analysis of multiple risks is the key to success in making any investment decisions.
And do not forget about the risk/profitability ratio.