Understanding Risk in the Market for Optimal Investments
As they say, change is the only constant. Be it social norms, cultural trends, weather, or market conditions, it all keeps on changing. The investor faces market risk when the market value of a financial product falls. It falls due to factors that affect the entire market and are not limited to a specific economic commodity.
However, the term ‘market risk’ is broad and has many different types, depending on the situation and financial product. To summarise, there are four kinds of risks- equity price risk, interest rate risk, commodity price risk, and foreign exchange risk. You can read about them in the following section.
Types of Market Risks –
- Equity Price Risk – If interest rates suddenly rise or fall, we can observe a rise in market volatility. Stock prices, more than other asset classes, can be highly volatile. A security’s price can change quickly, causing it to lose value. It is known as equity price risk. It is of two types- systematic risk and unsystematic risk. The first is an industry-wide risk, whereas the second is a company-specific risk.
- Interest Rate Risk – How sensitive a bond’s price is to interest rate changes & fluctuations is what makes the potential for a loss in the investments. If the interest rate increases, then the losses in the debt instrument are more likely to incur. It is what constitutes interest rate risk.
- Exchange Rate Risk – It is also known as the currency or foreign exchange risk, the risk associated with currency price fluctuations. Depending on the direction of the change, purchasing foreign assets becomes less or more expensive.
- Commodity Price Risk – Crude oil, gold, and corn prices can fluctuate dramatically due to political, regulatory, or seasonal changes. It is known as commodity price risk. Commodity price fluctuations may impact traders, investors, consumers, and producers.
Now that we know what market risks are, what do we do next? We reduce them. Let’s go over the two main methods for calculating market risks.
Risk Calculation Methods –
Value-at-risk is a statistical method for determining the extent of the risk (potential loss) & the likelihood that the loss will occur over a given time (occurrence ratio).
Beta compares a stock’s volatility to that of the market, as a whole, based on previous performances. In other words, it determines whether stocks follow the market.
Market risks should be understood and mitigated as soon as possible to get the most out of your investments. In the next section, let’s discuss how to deal with them.
If you need some ideas about what to read next, here they are:
- Portfolio Risk Assessment & Risk Management – Why Is It Important?
- The Importance Of Diversifying Your Investment Portfolio
- What is market risk premium and how to calculate it?
Ways to Handle Market Risks:
Here, we will discuss five specific methods for dealing with the market risks:
- Diversify to minimize concentration risk – Once we have determined the optimal asset class combination for our portfolio, we can reduce overall investment risk by diversifying our investments within the same asset class. It implies that if we invest in equity mutual funds, we should diversify by investing in large, middle, and small-cap equity mutual funds. When the market crashes, small-cap company prices fall faster than large-cap company prices. As a result, by diversifying our portfolio, we will lower our overall investment risk.
- Think long-term – You can manage volatility by taking a long-term and systematic approach. When you are a short-term trader in the market, volatility hits you hard. Equities tend to level off over time, according to historical data. A systematic or phased approach also helps to even out volatility.
- Know Your Risk Tolerance – Risk tolerance is determined mainly by the investor’s age and current financial obligations. It refers to an investor’s ability to bear the risk of losing their invested capital.
- Maintain Sufficient Liquidity in Your Portfolio – One way to maintain sufficient liquidity in your portfolio is to set aside an emergency fund equal to 6 to 8 months’ expenses. We should have low-risk investment options like liquid and overnight funds in our accounts to ensure easy access to emergency funds.
- Monitor Your Portfolio Regularly – If you are a long-term investor, you do not invest and then forget about your portfolio. You must monitor the performance of your portfolio regularly and conduct periodic reviews. You should review your portfolio every six months because some asset classes, such as equities, are prone to short-term volatility. As a long-term investor, you should pay less heed to the short-term and only make changes when your investments show poor performance over an extended period.
The bottom line is that you must exercise caution in maintaining and expanding your portfolio. Furthermore, working with an experienced firm like Secvolt is always a plus because they make your job easier. You can use the risk calculator tool (https://calculator.secvolt.com/ ) designed by them and secure your portfolio beforehand.
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