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The Fundamentals of Risk Managements
- Ethan Qian-Tsuchida
- Jan 19
- 5 min read
Every investment involves some degree of risk. In finance, risk does not necessarily mean losses, instead it refers to the amount of uncertainty or potential financial loss OR gain inherent with an investment decision. Risk management is a crucial tool in every investor’s toolkit, revolving around scanning for potential factors that may have negative effects on trades and taking steps to prevent that. Important things to consider when thinking about risk are how tolerant an individual is, how fast the money can grow, and how safe the money is. A rule to remember is the greater the risk, the greater the return.
Talking points:
Liquidity
Market Risks
Risk Tolerance
Many Strategies for Risk Management (7)
Creating a Trading Plan
Liquidity
Definition - the ease and speed with which one can convert an asset or security to ready cash without affecting the market price
For example, say you’d like to sell your used car whose market price is $4,000 (the price at which it can be bought or sold based on the current supply and demand). You may find someone willing to pay you only $1,000 immediately, which would be a huge reduction from the market price. Or you could wait longer, and find someone willing to meet your $4,000. In general, the quicker cash is exchanged, the lower cash the seller will receive.
Not everything has the same liquidity, especially in stocks. In established markets such as the US market and with large-cap stocks such as large corporations, which are traded very frequently, you can buy and sell immediately. While in emerging markets such as Egypt’s market and with small-cap stocks such as small companies with less shares, you might see delays when trying to buy or sell, negatively affecting your desired trade. Additionally, low liquidity stocks may see wider bid-ask spreads (the difference between the seller’s ask and the actual bids), which might increase losses or reduce profits.
Market Risks
Market risks are the uncertainties of the public market prices. Typically, unless you have control of a market-cap top 50 company or billions of dollars, these are risks you have no say on, and must adapt to. There are three major market risks: volatility risk, business risk, and inflation risk.
Volatility risk is the fluctuations in a stock’s price from the ebb and flow of the chaotic free market. It can also be influenced by things like a company’s faulty product or political events.
Business risk is an obvious yet overlooked risk. Returns from a stock of a company requires the company to still exist to pay you back when you sell. If the company goes bankrupt its assets are turned to cash, and you as a common shareholder will be left with the scraps or nothing at all. Something similar is in the case of bonds from a government. In the case of a government collapse, your bonds will disappear along with that institution.
Inflation risk is in reference to how inflation reduces the buying power of the currency, which is especially something to consider when an investor is receiving a fixed interest rate. A general rule when considering index and mutual funds is to find ones that can fight inflation (have a similar or greater rate of interest than yearly inflation).
Risk tolerance
Risk tolerance is the amount of risk you are comfortable with based on quantitative and qualitative attributes. It’s the measure of how much uncertainty you are willing to accept in exchange for the possibility of greater returns. This is based on your age, time horizon (how long will these investments be held), income, assets, financial goals, and especially personal preference. Financial advisors often use a calculated risk tolerance to recommend certain securities.
Strategies for risk management (7):
Avoidance
The first way you might manage a risk is to avoid that risk completely. This would mean investing in the safest assets such as bonds or T-bills.
Diversification/Asset Allocation
The primary risk management strategy for early investors is to invest across many different asset types. This would entail investing in stocks, bonds, real estate, and art or into different sectors of the stock market or even different country’s markets. The opposite of diversification is overconcentration. This can lead to significant losses in short periods of time when the specific sector you’ve invested a majority of your assets into takes a hit.
Hedging
This has become a buzzword, yet it is a rather advanced strategy that may not be advisable for new investors. Hedging uses strategies such as options, futures, and derivatives to offset potential losses from an investment. For example, say you expect a stock to move in the opposite direction from what you want. You might use a put option, which gives you the right to sell at a specific price, so when the stock price falls below that specified put price, you can execute the right to sell above the market value. There are a variety of reasons to hedge rather than exit the position, such as you don’t want to create a taxable event by selling.
Dollar-cost averaging
Let’s start with an example. Say you bought a share of stock X at $100. The value of that share just went down to $90. You could sell right now for a -$10 loss, or wait and hope the market goes in your favor by $10, back up to $100 to break even. However, you could use the dollar-cost averaging strategy to reduce the need for favorable major market movement. This would mean buying another share of stock X at the current $90. Now you have two shares with the average cost of $95 each, so the market only needs to go up by $5 for you to break even. By regularly investing a fixed amount of money, you spread the impact of market volatility over time. This helps avoid the risk of trying to time the market and lowers the average cost per share.
Stop-loss orders
You set a predetermined price that will automatically sell if your investment’s value drops below it. This is so that in the case of a market downturn your losses are capped to that price.
Rebalancing
As investments grow and change, their percent makeup of your portfolio changes. Over time your portfolio deviates from your initial intentions and may no longer align with your risk tolerance and investment goals. By shifting money from one investment to another, you rebalance your portfolio.
Safe-haven Assets
These assets typically move contrary to the market. So in market downturns, your risky investments are offset by the safe-havens. These include government bonds, high-quality corporate bonds, and metals such as gold.
Creating a Trading Plan
After determining your risk tolerance, future financial goals, and the rationale for all your trading decisions, you should combine them into a trading plan. This is a template to keep you on track with your original goals in the context of whether the market is bullish or bearish.
You may also want a training plan. As you learn new investment skills and develop strategies, you can use this training plan (which can be tested on any paper trading app or website) to try out any new developments before implementing them with your actual money.
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Written by Ethan Qian-Tsuchida
Newton South High School student
Interests in finance, economics, risk management, and teaching others about fun topics to make the world of finance and economics approachable.
Email - ethan.qiantsuchida@gmail.com
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