Risk Management

a constant presence in the investor’s life

In order to be good at investing, you have to also manage risks, in addition to the actual investing activities. This statement above is valid regardless of the type of your investments: stock market, commodities, real estate, cryptocurrency, etc.

So, why do we need risk management?

We need it because all what we do is risky. Not only the investments, but actually all that we do in our lives comes with a certain degree of risk. Sometimes we consider it, other times we ignore it, but it (the risk itself) is there always.

Some risks can be eliminated, others can only be accepted and mitigated. That is why, the best action to be taken is to understand each and every risk associated to our investing activity and define some action steps for the biggest risks.

Therefore, we can consider a risk management plan based on 3 (three) steps:

1. Identify the risks — ask yourself what could go wrong, or in other way than you have imagined it, or other way that it happened in the last years — and make a list with all of these things.

Here are some examples: bonds that could reach end of life before the initially announced date, companies that are famous for giving dividends yearly could change this strategy just in the year when you start buying their shares, etc.

2. Prioritize the risks — once you have identified all things that could go wrong, review them all and rank them in the order of their potential damage: first the absolute worst ones, then the so-an-so worst ones, and then the acceptable ones.

Usually, here it is recommended to use just a few levels of potential damage, or priority: the worst damage has priority 1, the so-and-so has priority 2, the acceptable has priority 3. If you identify a critical life-and-death risk, that one can have priority 0.

3. Mitigate the risks — do all that you can do to prevent risks from happening or to make them acceptable if they really have to happen. In most cases, this means to do any or all of the following actions:

• Accept that you can lose all of the money you have invested.
• Decouple yourself from the invested money by having an emergency fund.
• Take decisions when you are not under pressure: use Take Profit & Stop Loss.
• Focus on diversifying your portfolio by industry, geography, etc.
• Invest in ETFs rather than individual financial instruments.

Generally speaking, the risk of the investment is in a reverse proportionality relation with the length of the investment — this means that generally speaking, the risk decreases when the duration increases, and the other way around.

This is one of the reasons why it is recommended to buy periodically the same instrument: because by increasing the acquisition period, the risk of buying at a “bad” price decreases, because over time the price itself tends to go to the average value.

Another action that we can take is to always search to have a 1/3 ratio between risk and reward: the potential reward to be two times bigger than the risk taken.

From another perspective, the risk is necessary because it makes the win possible.

We can say that there are two main risk categories:

• Instrument (security) risk — we reduce it by diversifying the portfolio;
• Investor risk — we reduce it by educating ourselves (the investors).â

In the title of this article is mentioned that risk management is always part of an investor’s life because this activity is actually on everybody’s agenda, doesn’t even matter if they like it or not.

Here is a list with some of the most common risks that investors have to deal with:

• Risk of losing part / all of your money — easy to understand, no need to explain it with more detail;
• Risk of missing an opportunity — it is always present, because there will always be opportunities that you will not know of;
• Risk of inflation eating your earnings — if you earn 5% per year and inflation is 7% per year, this risk has come true and actually you have lost 2% that year;
• Risk of the company where you are invested to go bankrupt — if you have shares at accompany and that company goes out of business, there are big chances that you have lost your money — or you will get it back with a (big) delay;
• Risk of bonds maturing early before the initially announced date — you have bought corporate bonds that promised to pay interest for the next 5 years, and you have made plans for that 5 years of interest — and they decide to close the bonds after only 2 years — then you have lost the promised interest of 3 years;
• Risk of geopolitical hazard — this risk is most present when you buy assets from countries that are still in development and where, generally, the governments are not quite stable, and they tend to change the (fiscal) laws quite often;
• Risk of liquidity — this comes true when you have put your money in an instrument that is no longer wanted by the other investors — meaning that even if you want to sell it, there is nobody in the stock market willing to buy it; page 3 of 3
• Risk of market — you invest in a market that goes through a recession and all assets present in that market suffer the same depreciation.

Some investors have a proactive approach and think about the risks before they happen, while others have a reactive approach and they just deal with the risks after they have happened.

At the end, we leave you with this saying, which is a personal adaptation after a famous quote: it’s not the risk itself that gives us trouble, but not knowing the risk, not accepting the risk, not mitigating the risk, that generates the biggest problems. Also, this statement is valid for each and every area of our lives, not only investments.

Article written by Aurel Rusu — founder of investeo.ro