Before managing the risk in investment, investors need to understand the basics of risk, and the cause of the risk first. Then, investors can manage the risk to limit the risks that may arise from the investment. Therefore, this article provides the definition of the investment risk, and also its management principles.
What is the investment risk?
Investment risk is the degree of uncertainty in achieving the expected return of an investor. It is the extent of the outcome that investors cannot predict. Investment risk is an important element in evaluating investment opportunities. Most investors think that the less the risk, the better. However, in the investment market, it is well known that high-risk investments can give a high return as well.
Where does the risk come from?
In fact, investing in each asset type tends to have different investment risks. However, risks are mostly divided into two main categories as follows:
Systematic Risk
Systematic risk, or market risk, is a risk that may affect the market or the overall economic sector. Examples of systematic risk are political factors and macroeconomic factors such as interest rates, inflation, deflation, etc. If the economy is good, asset prices will increase. At the same time, if the economy is in a recession, asset prices will fall. These are often inversely proportional to market forces.
Unsystematic Risk
The unsystematic risks, or specific risks are risks that affect the industry or only one company. An example of unsystematic risk is industry trends. If any industry is in an uptrend, industry asset prices will increase. Moreover, company performance is largely dependent on the type of business, products, services company strategy, as well as the ability of the executives. Importantly, this performance is a variable directly related to that company.
What are investment risk management principles?
Investment risk management is the process of managing factors and controlling activities to reduce the potential cause of investment damage. This risk has to be managed in order to retain the level of risk and impact at a level that investors can accept and control.
3 Investment Risk Management Principles
1. Asset Allocation and Diversification
In the investment market, investors should not invest in a single asset class. The reason is that if there is a crisis, investors can lose all their money. Thus, investors are advised to combine different asset classes to diversify their investments. Investors can diversify their investment into various assets such as bonds, stocks, gold, oil, and real estate. If investors are unable to diversify across assets, investors may consider diversifying into other industries under the same asset class.
However, the allocation of investment assets should be based on the acceptable risk of each person. Moreover, funds for asset allocation must also be considered. Diversifying the investments allows investors to minimize the risk of massive losses. It can arise from overemphasizing a single asset class.
2. Investing Consistently
Regular investment or dollar-cost-average is another way to reduce investment risk. This is because asset prices can fluctuate all the time depending on different factors. Importantly, all of them are difficult to predict. Therefore, if investors buy that asset regularly every month, investors will be able to purchase such securities at the average cost price throughout the investment period. Investors can invest without worrying about market price fluctuations. Furthermore, investors can eliminate the risk of mistaking timing.
3. Long Term Investment
A long-term investment is another way recommended by experts. In fact, short-term investments tend to face high volatility. However, if investors invest long-term, they can help eliminate the risks that may arise. This is because assets are usually growing in the long term. Finally, this causes asset prices to rise. In addition, long-term investments tend to yield higher returns than short-term investments. The recommended period is from 3-5 years or more.
In summary, investment risk management is a method that allows investors’ portfolios to generate good returns in the long run. It can reduce the chance of loss to a minimum. Investors can manage the risk by diversifying their investments with the dollar-cost-average method as well as investing for the long term. Finally, these will allow the investor’s portfolio to reduce the risk from various factors.
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Source: Investopedia