Risk Management – Concept, Types, Significance, Approaches, Strategies, Tips & moreLast Updated Date: May 11, 2022
In this article, we’ll discuss Risk Management thoroughly in the stock market. This will be helping traders on how to earn profits through a prudent move.
Among most amateur traders who didn’t even step into the stock market, it has often been assumed that the stock market is a shortcut.
It has the massive potential of making someone rich within one day or month. However, it’s true, but with an incomplete verity.
Despite abundant opportunities, the stock market is still holding a notorious position. The leading reason is that only a few people enjoy profits.
A big count of investors has to lose their money, which happens because of their unnecessary or ineffective predictions.
The stock market’s all-time fluctuating patterns are unpredictable. In most instances, it happens that without any notice, the ‘entire money’ that investors had invested gets wiped off within a few seconds.
It doesn’t matter; these were professionals or fresher. That’s why if you want to try your luck here, then don’t depend solely on your fortune.
Show some smartness and become familiar with the fundamental principles of the stock market.
The risk and return relationship, not just in the stock market but in every trading sector, is quite similar.
Therefore, before getting driven towards high-returns that a particular investment is promising you, make sure you are first introduced to the underlying risk level associated with it.
You must understand that risk doesn’t particularly indicate losses in the stock market. Indeed, it’s a much deeper concept that every serious trader must pay attention to.
It is like a challenge that examines your intellectuality because high risk has a deep connection with high-returns.
How much risk can you bear on a particular investment? You’ll have to understand it first. So conduct your risk assessment, needs, and financial goals. Mark everything in this assessment.
Similarly, assess the potential types of risks associated with your investments. Do you have sufficient funds behind for an emergency?
For example- in most instances, you want money, and you’re likely to withdraw money from investments.
Still, unfortunately, the money is locked-in, which can be a disadvantage to you. You’ll be unable to arrange the required money on time.
That’s why prior to getting stuck into any risk, make sure you first acknowledge all underlying risk factors. Then, come up with a management plan.
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Types of Risks
Below, we’ve listed some significant risks that crop up in the stock market. Each risk is subdivided into the categories stated below:
Equity Risk: You want to invest in equity because from here, you’ll get a high return as compared to others.
But don’t forget that ‘equity investment’ is deemed one of the riskiest investments. This single investment can bite off your money, thus invest carefully.
Interest Rate Risk: The fluctuations in the interest rate are also a big risk that plays a significant role in influencing the market.
The recession or the country’s economy can be the most dominant reason behind a decrease or increase in the interest rates.
Currency Risk: If a business is operational at the global level or a company relies on foreign investment or currencies, it can significantly impact its shares.
The value of each country’s currency is different, and it also increases or decreases over time due to economic factors.
Reinvestment Risk: It’s also one of the most underestimated risks associated with investments. For instance, you put a few amounts from your savings into Fixed Deposits (FDs).
Since the FDs mature from time to time, and the interest rate doesn’t remain the same, it can trigger the problem.
It is because you are inbound under the condition of reinvestment. That’s why you should pay attention to the renewal time before you start investing in FDs.
Credit Risk: If you’re planning for investment in securities and bonds, you’re likely to deal with credit risk associated with such investments.
Credit risks are like when the issuer of a bond fails to pay the requested money. It is in the same manner just as an insurance company fails to pay the claim when required.
Tax Risk: It’s one of the most problematic concerns that professional investors often encounter.
Returns associated with particular investments can be a subject of Taxation, and you can’t ignore or refuse to accept the Income Tax Policies if you don’t want yourself to get stuck into the legal matters.
But, you can get rid of this problem through some strategies.
Inflation Risk: This risk also refers to as the purchasing power of the money risk because a higher inflation rate reduces the buying potential of the investors.
That’s why you should pay special attention to inflammation and how the rate changes.
When you’re focused on a particular investment and concentrating solely on it, you’re welcoming concentration risk.
The stock market is unpredictable. If you’ve spent your entire money in one basket, the risk of losing the entire money becomes higher.
So these are some of the ever-green risks in the stock market. Thus, you’ll have to stay active all time if you’re going to put an immense amount on investment.
Next, we’ll glance at the risk management strategies to mitigate the emerging possibility of risk before they convert into a huge loss and trigger imbalances in your financial position.
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What is Risk Management?
The risk isn’t hidden from us; in all spheres, the risk is a chief matter of concern.
On the flip side, risk management can be assumed as a decision-making process to minimize the negative impact in the future associated with a certain risk.
As said, the types of risks vary based on your selection of platform for investments.
Therefore, the proper analysis and the right response to risk before time can protect you from unwelcome losses.
As an investor, to mitigate the potential risk, you should take appropriate actions. Only then you’ll be able to maintain your position in the financial market.
However, since every investment is comprised of a certain level of risk, so risk management becomes equally essential for every investment.
In this, your solid understanding of the risks will assist you a lot in further steps.
Importance of Risk Management
Beyond doubt, Risk Management plays a crucial role in the stock market. It’s an important process that focuses on the utilization of tools and strategies.
Ultimately, the identification of potential risks becomes easier.
To enjoy the proper effectiveness of the risk management strategies, an investor needs to obtain an in-depth overview of the potential risk emerging or likely to emerge in the market.
On the ground of the obtained data, an investor can think about bringing risk management strategies into action.
In most instances, throughout the process, investors also derive additional insights and get access to some lucrative opportunities.
That’s why risk management becomes a crucial segment of the stock market. It helps an investor make informed decisions and observe stability in his financial position.
Let’s understand Risk Management more deeply through the following approaches:
Risk Management Approaches
Before you implement the risk management strategies, you should know about the risk management approaches.
Professional investors focus on these approaches that help them to stand out in the market despite the uncertain environment.
It’s nearly impossible to eliminate all types of risks because few risks are dominant in nature.
And they impact the entire stock market, e.g., global pandemic, and everyone knows how it has impacted the economy worldwide. Hence, certain types of risks can’t be avoided.
On the other hand, if the market slope is at its peak and the price of goods or services is also high than its original price, it’s recommended to avoid purchasing.
In the future, the price of this good can decline at a fast pace. It can probably derive huge losses and negatively impact your financial position.
It’s one of the most common approaches that companies or investors follow. Risk reduction can be viewed as art because, in this way, investors reduce the possibility of potential risk.
The risk isn’t avoided, but it’s outcome impacts the financial position of the investors at a reduced level. Thus, an investor finds himself in a balanced position.
In most instances, the risk becomes difficult to avoid and hard to be reduced. Consequently, the risks are then divided.
For example- if you split up your investment in two risky capitals (in a different industry) that are promising higher returns, you’ll be creating a secure investment.
If one of your investments has incurred a loss, your second investment will be available to offset the loss through profit.
Companies and investors follow the ‘risk retaining’ approach if the expected gain exceeds the costs of potential risk.
If a company wants to keep the risk from a business standpoint because they are observing potential benefits in it, they will follow this approach.
Best Risk Management Strategies
Here are some of the best risk management strategies used by investors or traders.
Following Market Trends
Ask any professional investor; they all have the same opinion. Investment, according to the trend in the market, can end up providing you with higher returns.
That’s why you should follow the market trends because it is a highly effective strategy helpful to mitigate risk before time.
However, the only shortcoming of this strategy is, market trends often become challenging to predict.
It happens because of numerous dynamics and an ever-changing economy. Still, if you’re able to identify the trends that last for the short term, you can earn profits.
On the other hand, if you’re fully confident about the particular trend that’s likely to last for a longer duration, you can earn huge. But remember, it’s a difficult task.
Diversifying Investment Portfolio
It’s the best part of the stock market that you’re allowed to invest in numerous fields. Such as equities, bonds, mutual funds, derivatives, etc.
As an investor, if you’re willing to invest your saved money in the Indian stock market, feel free to choose the best investment alternative for you.
But don’t focus on any particular investment. You should reap the benefit of other alternatives, and instead of investing in a particular stock, invest in many from a different industry.
Hence, the potential risk is diversified, and you obtain profits without the fear of losses. In this way, you’ll be protecting your overall returns.
And despite market fluctuations, you’ll be establishing a well-balanced investment portfolio.
Avoid Quick Decision
Don’t come across any decision through emotions when it comes to the stock market. If a company is doing brilliant, it doesn’t imply that its futuristic performance can derive high returns in your portfolio.
That’s why instead of a hasty decision, you must make informed and sound decisions and pay attention to prices. Give time to the extensive research and come up with the best possible action.
Professionals first create a chart of the market pattern depicting which things to avoid and where to go fast. They then come up with an accurate investment decision.
Also, don’t forget your financial objectives and pay attention to the liquidity.
You should have sufficient balance available behind to support you in an emergency because, in such situations, you’ll be unable to withdraw your invested money on time.
Risk Management Planning for Trading
History witnesses, without planning, no one had ever won the wars. In the modern stock market, too, planning is the chief segment.
It really clears all the differences and helps you in identifying the best possible action that should be taken at a particular point in time.
For instance- through placing the stop-loss and take-profits, you can play safe. You can pre-determine the entry point in the market, so you instantly purchase the stock at the expected value.
Similarly, you can pre-determine the exit point in the market, so you instantly sell the stock and enjoy the anticipated returns.
Those investors who skip using stop-loss or take-profit point can find their money being vanished within a few seconds.
On the other hand, those investors who don’t make a wise selection to determine the price for entry or exit point also gain nothing.
Through these two essential things, nowadays, investors are earning huge. However, both these points are quite helpful for intraday trading.
But if you want to play in the long run, you can skip this option because there it can become a disadvantage to you.
As an investor, if you want to prevent yourself from losses and are ready to sell the stocks at the lowest price point, you’ll use a stop-loss.
Stop-loss assists you in the situation when the market is facing downturns. If it’s falling below your set limit for stop-loss, you’ll be able to get back your invested amount at a reduced amount (for the limit set by you in the past).
Owing to stop-loss, you don’t have any need to analyze the market all time. If the market is going down, your money will be safe.
But, in this way, you earn nothing because, on the flip side, it happens in most instances that the market position goes down for a few minutes, and suddenly it glides up.
Since you’ve withdrawn your position through stop-loss, you’ll be unable to enjoy the benefit of such conditions.
That’s why try to place the stop loss accordingly. Playing in a too much safe zone might end up biting your investments a bit-by-bit, and instead of earning, you’ll be losing.
It’s the price point decided by you at which you’re willing to sell the shares.
In short, you book profits, and if fortunately the price of your book stocks increases and reaches your set limit, the system will automatically sell your stock.
Therefore, you’ll obtain the anticipated return. But it also has a shortcoming.
As an investor, if you become too greedy and set the take-profit higher above the previous higher points, you might obtain nothing.
Ultimately, you can fail to capture profits with a minor difference. Possible, that next day market observes downturn, and there you can earn losses.
Risk Management Tips
Here are some of the major Tips in Risk Management –
Analysis of the Performance of a Company
Make sure you pay attention to the company’s performance, its historical value in the market, and what are its future plans.
If the company is hi-tech and planning to invest more in technology, you can think about purchasing their stocks. Even though their shares’ value is declining, you can still trust them.
They are going to bring something bigger and better to satisfy the customers; thus, you can expect an upsurge in the demands of its products and services.
Similarly, you can enjoy high-return in the future.
Spend Time and Money on Loss Control
A proper overview of the company is essential. If the company is offering big returns, then don’t be too greedy. It’s the silliest mistakes that investors make.
Instead of profitability, you should focus more on loss control. Check out the previous decline points of the company when its shares’ price fell, set the stop loss accordingly.
Don’t go down to that, and don’t play too safe. If you’ve enough time to give to the market, then don’t use stop loss and individually decide when to exit or enter the market.
Calculate Expected Returns
Calculate the expected return keeping the potential risk in mind. If a company is promising you a high return, then don’t overlook the risk percentage associated with it.
For instance-through an analysis, if you find the risk and return ration 50-50, step back immediately.
There are equal chances that you might end up losing your money. On the other hand, if the return ratio exceeds the risks level, then you can think about going one step ahead.
Still, the risk probability can alter the entire game in the end. Hence, you should invest only if you’re fully confident in a particular investment.
Identify the Risks Earlier
It’s much better if somehow you identify the risk much better and exit the market before time. The fast you’ll make a move, the better you’ll feel in the end.
In most instances, the company goes bankrupt; thus, it is possible that later they have nothing to give you.
So make sure you pay attention to any alert indicating the decline in the position of a company where you’ve invested.
Limitations of Risk Management
Risk management can be a bit costly for you if the ratio of your investment is small and liquidity is also minimal.
For proper risk analysis, analysts use models and simulations which consume enormous cost.
This is because they have to gather massive data, which raises expenses. Still, the gathered data will provide favorable insights or not; it remains a topic of uncertainty.
In most instances, you get insufficient data, resulting in you derive poor outcomes.
For the proper analysis, you’ll require trained and reliable analysts with decent to professional level skills if you were willing to invest in a big amount.
Also, the data is driven by historical patterns. And what risk the company has obtained previously; you can gather entire information on such things.
But, what are the problems the company is going to encounter, and liabilities on the company?
All such things become difficult to depict. That’s why you can’t rely entirely on risk management. You’ll have to show more intellectuality.
It is difficult to see the cumulative risk in the big picture. That’s why, sometimes, risk management becomes immature.
Risk Management – Conclusion
Now, you have become well-acquainted with risk management, how to employ strategies, which things to notice first, and last.
All these things really make sense if you want to stand out in a risky environment. You first need to be fully assured about your risk-taking capacity.
How much risk you can bear- first, create a chart of your financial position and study every parameter.
You should have consent on the money that you can lose, and it’ll not impact your balance sheet. If your strategies are good and your predictions are right, you can double this money.
If you remain unfortunate, you can again take a look at the points discussed above, so at least you don’t lose the entire money.
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