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Risk is the possibility of a negative outcome. While most of us deal with different risks every day, financial risks can be tricky. An action or activity that brings loss is called a financial risk, which can affect your objectives. 

 

Financial risks arise from a firm’s ability to manage its debts and fulfil its obligations. As a result, you are planning several direct and indirect risks. The quantum depends on the product you are investing in. Therefore, every entrepreneur or enterprise must manage its financial risk exposures. 

What is Risk Management in Finance

Financial risk management refers to identifying the possible risks in advance, analysing them, and taking precautionary steps to either avert them or deal with them. Risk management will provide you with a set of tools and techniques to measure as well as manage these risks.

Investment Risk Management

Investment risks occur when the investment that you have made brings a result other than the anticipated one. As a result, you may lose some or the whole of your invested fund.  For example, you made an investment hoping for a return of 5%; however, in the required time period, the profit was a mere 2%, or rather than making a profit altogether, you lose on your investment. 

 

While the concept of ‘risk-free investment’ is a myth, managing the risk is possible. It simply means investing your hard-earned money safely. With investment risk management, you acquire the knowledge to build a suitable investment portfolio. Then, while well within your client’s risk boundaries, you make appropriate investments and reach the required financial goals. 

Risk Tolerance

When discussing risk management, it is essential first to understand your or your client’s risk tolerance. Risk tolerance, as the name suggests, refers to the loss an individual is ready to bear when they invest. Knowing about the amount of risk one is willing to take, an investment portfolio can be made. 

Factors Affecting Investor’s Risk Tolerance

Every individual’s risk tolerance determines their investment portfolio; thus, risk management is done accordingly. There are, however, a few factors that affect an investor’s tolerance of risk, let us take a look at them: 

1. Risk Capacity

Every investor can have their risk-return principle and a different appetite for risk. While some are more comfortable investing aggressively, some are naturally more satisfied keeping their investments safer. Investors can be classified into three broad categories:

  • Conservative Investors

    Such investors like to take the least risk and do not prefer indulging in investments that can be risky. They generally have limited-return options, including FDs, postal schemes, PPF etc.

  • Moderate Investors

    Moderate investors are the ones who are more risk-tolerant compared to conservative investors. They do not mind taking a few risks and mostly have a fixed percentage of losses they can handle through a more balanced approach.

  • Aggressive Investors

    As the name suggests, such investors are generally more experienced in how the market works and thus, can take more significant risks. In addition, aggressive investors are more actively involved in their investment portfolio.

2. Need

One investor's financial goals and needs will differ from the other. Therefore, the investor’s needs can determine his risk tolerance. Someone with a significant upcoming expenditure may not want to take too big a risk.

 

3. Age

Generally, younger people who do not have too many liabilities like to take more risks in their investments.

 

4. Time Horizon

Every individual who invests has a probable time horizon for which they wish to invest. For example, if an investor wishes to keep investments going for 20 years, they may be ready to take more risks compared to someone with a time horizon of 5 years. 

Important Steps Involved in Investment Risk Management

Effective financial risk management means being proactive rather than reactive.  Let us take a look at the steps that are involved in the management of risk:

  • Step 1: Identification of risk

    The different sources of risk are to be identified and then prioritised. Simply put, dealing with all existing risks together at the same time may not be possible. 

  • Step 2: Assessment of the risk

    Sometimes, along with finding ways to handle the risks, you also need to understand the causes of such a risk. You need to assess the frequency and ways to avert such situations. 

  • Step 3: Controlling the risk

    To control the risk, you need to develop an appropriate strategy/ response to manage the risk. The aim is not just to manage the ongoing risk but also to avoid it in the future.

  • Step 4: Reviewing the control

    Reviewing your ways and means is crucial, especially when dealing with recurring identified risks. The ideas need to develop into a number of contingency plans that can be deployed as and when required.

Strategies to Manage Investment Risk

You must remember that just about every investment product comes with a certain amount of risk. While risk and return are inseparable, various tactics can ascertain risks. 

 

  • Diversify your portfolio

    The age-old maxim of not putting all your eggs in one basket stands true in the capital market. With an asset allocation across different sectors, even in the scenario of the downfall of a particular company, your other investments would be safer.

  • Turn down the volatility in your portfolio

    When you move towards risk aversion, your risk factor becomes relatively low. So make sure you allocate a certain percentage to cash and liquidity. Market risk, known as beta, will help you understand the concepts of active and passive risk.

  • Consistent investing

    For a risk-free rate of return, you need to be patient and disciplined. Most investment products give the best results in the long run. Try keeping your emotions out of this process.

  • Make an analysis

    You must identify your current position as well as your goals so that you can create your plans accordingly. Create a mixture of assets and thus relieve the pressure points in your investment portfolio.

  • Keep a margin of safety

    When to buy and when to sell can be a little tricky. Therefore you need to have a safety margin, as the risk-taking capacity varies from investor to investor, so does the margin.

  • Establish a loss plan

    This will allow you to carefully manage your asset allocation and thus help you avert making bad investment decisions. But, first, you need to measure an asset’s peak value and lowest point. 

Conclusion

When it comes to building a financially strong future, you can’t really leave it all up to luck. Every investor is different; while some focus strictly on quick returns, some like to be more cautious. To control and minimise the exposure to risks, risk and return on investment need to be balanced; this is where a fund manager can help you better. In times of economic turmoil, inflation, recession or bankruptcy, professional help can come in handy.