Everyone faces risks daily, in commuting, doing tasks for work or school, and even in doing simple chores. The degree of risk varies greatly, but nearly every action we take has a possible negative outcome. However, in our day-to-day lives, we hardly notice or even think about the risks we’re taking. That’s because the methods we use to manage those outcomes have become so ingrained in our daily routines that the dangers become an afterthought.
However, higher stakes and less patterned behavior leave us with very noticeable feelings of peril. If unloading TVs is your job, you get used to it after some time and give it minimal thought. However, if you’re just a TV buyer, you’ll be quite cautious in carrying it to your car and setting it up in your home. Simultaneously, you won’t be as careful with a less pricy appliance, such as a blender.
All of that translates into financial trading as well. Each investment has the possibility of underperforming and either making less than expected or even nothing at all. And as we do in real life, in trading, we employ various risk management tactics that minimize the chances of things going south. However, that risk is never non-existent and threatens to topple even the most skilled investors.
With more experience, you become more proficient at minimizing danger and slowly begin to internalize the process. However, each trade or investment is different, just enough to keep risk control a cognitive rather than a passive process. So, while investing risk mirrors day-to-day dangers in many aspects, it also has its particularities. To become better at avoiding troublesome situations in investing, you need a better understanding of risk itself. So let’s dive a bit deeper into the specific dangers of trading and investing.
Risk and Reward
We already touched briefly on this topic, but let’s go slightly deeper into it. We usually take risks because of the rewards the perilous actions might bring us. That’s true for both day-to-day risks and investing ones; however, it’s much more apparent in the latter. After all, you know exactly how much money you invested and how much you got out.
So what’s stopping people from only going for low-risk trades? Technically nothing, but realistically, it’s the fact that risk and reward are mostly proportionate. Going for safe investments often brings incremental gains, but since the profit is small, it can get wiped away with one trade gone wrong. On the other hand, high-risk, high-reward transactions have their own downsides that are more apparent in huge financial fluctuations.
So with both extremes having their benefits and disadvantages, what’s the correct way to handle risk? Well, that depends on an individual’s risk profile. Risk profiles are a rough guideline at how able and ready an investor is to handle different types of danger. Many determine their risk profiles through a questionnaire, done either online or professionally.
Risk is an inherent thing while trading, meaning you can’t change the level of risk of any particular trade. As such, danger management comes down to assessing whether the potential award outvalues the peril and bracing yourself for the negative outcome.
However, to properly assess risk, you need to recognize it. And to spot it, you need to know what you’re looking for, so here are some relevant investment-related risk categories:
Country Risk: The risk that a country won’t honor the financial commitments it made. It can influence that country’s financial instruments, as well as those that cooperate with it.
Business Risk: With company stocks and bonds, there’s always the danger of it going under. Common stakeholders are last in line in that case, meaning you can be left with nothing.
Volatility Risk: Even if a company doesn’t entirely swing, its stocks can fluctuate wildly. However, volatility is more prevalent and difficult to predict than business risk.
Political Risk: Political decisions in a specific country can impact the functioning of their financial assets.
Interest Rate Risk: The danger of an investment’s value dropping because of a change in the absolute level of interest rates.
Liquidity Risk: The possibility of an investor not being able to “cash in” on their investment. It should be noted that there’s extensive literature on risk management and that it’s a skilled investor’s prerogative to spend extended periods developing. You can’t expect to read a few articles and become an expert, as they serve as more of an introductory tool. If you master it, however, it might greatly assist you in maximizing your earnings.