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Risk Management Essentials: Preparing for Successful Investments

Before you start investing in various financial instruments, it is critical to understand the risks that you will consequently face. When it comes to investment, risk is inseparable from returns. Investment decisions are made after considering all the possible risks and to what extent you can contain, avoid, or manage them. This article will give you an insight into the type of risks you will uncover during your investment journey and the various risk management techniques you can adopt to handle them.  

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What is risk management? 

Risk management includes identification, analysis, and acceptance or mitigation of uncertainty in investment decisions. It is the process of keeping an eye on and managing the financial risks involved with investing. Risk management primarily involves you or your fund manager evaluating and trying to compute the possible losses you might incur in an investment. Accordingly, you must formulate an action plan to avoid these losses.

Types of risks

The following are the types of investment risks:

  • Market risk: The risk of the value of your investment decreasing due to economic developments or other events that affect the entire market. You can come across Equity, interest rate, and currency risk three types of market risk.
  • Liquidity risk: The risk of your inability to sell your investment reasonably and cash it in your time of need. This implies that you can either sell your investment at a lower price or not able to sell it at all.
  • Concentration risk: This risk occurs when you fail to diversify your investment portfolio and invest in a single type of investment. Failure of that one investment will lead to terrible losses.
  • Credit risk: The risk of the government entity/company that has issued the bond failing to pay interest on your investment or even failing to pay back your principal amount on maturity.
  • Reinvestment risk: The risk of reinvesting your funds at a lower interest rate. Funds can be either principal amount or returns earned on previous investments.
  • Inflation risk: The risk of inflation surpassing the value of your investment, leading to a reduction in your purchasing power. 
  • Horizon risk: The risk of withdrawing your investment before the planned period. You might be required to do so due to sudden health issues or job loss.
  • Longevity risk: The risk of living longer than what your savings can sustain. You live more than what you had planned for in terms of investments.
  • Foreign Investment risk: The risk of investing in overseas nations, which might entail unforeseen circumstances.

Risk management mechanisms 

The following are the methods of risk management:

  • Avoidance: You can completely dodge the risks by investing in the safest investment options, which involve negligible risk.
  • Retention: You open-mindedly recognise that risks are part of investment. You accept the risks associated with various assets and deal with them as they emerge.
  • Sharing: Instead of assuming the entire burden of risk, you distribute it in a specific ratio among two or more parties.
  • Transferring: You transfer the complete burden of risk to another party. Health insurance is a perfect example where the insurer assumes the entire risk if the insured pays premiums on time.
  • Loss prevention and reduction: Instead of trying to eradicate the possible risks, you identify methods to reduce the magnitude of loss. You can do this by impeding its spread. You can effectively implement this technique by diversifying your investment portfolio.

To sum it up 

You cannot eliminate the risks from the investment world. So, you must understand and undertake risk management before making investments. First, establish your final target and evaluate the risks accompanying those objectives. Once the risks have been identified and quantified, determine the best technique to manage the risks. Sometimes, you might have to implement multiple risk management methods. You will have to review your risks and modify your techniques accordingly continuously.

 

Related Articles:  What is a Death Cross | What is Pyramid Trading | Understanding Dividend Payout Ratio

 

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