A Beginners Guide to Understanding Risk Management
What is risk management?
Throughout our lives, there are always going to be risks to manage - whether it is during simple tasks (such as driving a car) or when we make new plans for our health or insurance. Risk management is primarily concerned with assessing and responding to risks.
Most of us manage risks unconsciously in the course of our daily activities. The fact remains, however, that assessing risks is a crucial and very conscious practice whenever we are dealing with the financial markets and business administration.
The only way we can describe risk management in the context of economics is that it is an approach that describes how a company or investor deals with financial risks, which are inherent to all kinds of businesses. The framework may be beneficial to traders and investors interested in managing multiple asset classes, such as cryptocurrencies, forex, commodities, shares, indices, and real estate.
The financial risks can be classified into many different types depending on how they are classified. In this article, we will discuss how we manage financial risk in a better way. It also provides some strategies that investors and traders can use to mitigate financial risks.
How does risk management work?
The risk management process is usually divided into five steps: defining objectives, identifying risks, assessing risks, defining responses, and monitoring. It is important to understand that the order of these steps can differ considerably depending on the context.
Setting objectives
The first step is to identify the primary objectives. This is often dependent upon the company or person's ability to tolerate exposure to risk. It refers to how much risk they are willing to take in order to accomplish their goals.
Identifying risks
The second step entails recognizing and describing the potential risks in the organization. The aim of this step is to identify all of the possible events that could negatively impact the project. Taking this step in a business environment can also provide useful insight that doesn't directly refer to the business's financial risks.
Risk assessment
The next step would be to evaluate the risks based on the frequency and severity they are expected to occur. The risks are then ranked in order of importance in order to make it easier to formulate or adopt a response to address the risk in a timely manner.
Defining responses
According to their level of importance, the fourth step is to define one or more responses for each type of risk. This document specifies the actions to be taken in the event of an unfavorable event.
Monitoring
An important part of the risk management strategy is monitoring its effectiveness in response to events, so that it can be optimized. To accomplish this, it is often necessary to collect and analyze data continuously.
Managing financial risks
In order for a strategy or a trade setup to fail, there can be several reasons for it. The market could move against the position a trader holds on futures contracts, and as a result he or she could end up losing money because of the move or because they get emotional and end up selling out of panic.
A trader's emotional response can cause him to ignore or abandon his initial strategy due to his emotional reaction. This can be particularly evident during periods of bear markets and capitulation.
Many people agree in the financial markets that having a good risk management strategy is one of the most important factors that contribute to their success. As a practical matter, this could be as simple as setting a Stop-Loss or Take-Profit order. However, there are numerous ways to manage risk. These strategies should ideally be continuously revised and adapted.
A few examples of financial risks are provided below, along with a brief description of how they can be mitigated.
Market risk
- The risk can be mitigated by putting in Stop-Loss orders on each trade so that positions are automatically closed before losses become too large.
Liquidity risk
- The liquidity risk of trading a person's stock on a high volume market can be mitigated. Assets with a high market capitalization value usually have a higher liquidity level.
Credit risk
- This is a risk that can be reduced by trading through a trustworthy exchange, which removes the need for the borrower and lender (or buyer and seller) to trust one another.
Operational risk
- Investing in diversified portfolios allows investors to minimize operational risks, as opposed to concentrating their investments on single projects or companies. It is also likely that they will perform some research to identify companies that are less likely to be affected by operational malfunctions.