Every investment, no matter how safe it is considered to be, brings with it an element of risk. In the financial domain, market risk is defined as the possibility of an investment’s actual returns differing from the expected returns. Inappropriate risk management can result in the loss of some or all of the original investment.
Risks are of various types:
This risk present within the entire system, market or market segment. It includes the risk of key events like a government’s collapse, war, inflation, or others like the subprime mortgage crisis in the United States in 2007. It is practically impossible to protect your portfolio against these risks, as it cannot be eliminated through portfolio diversification.
This is a type of systematic risk, and comes with the risk of losing investments owing to factors like political, macroeconomic and other major risks that affect the performance of the overall market. Here too, portfolio diversification cannot be used to reduce or eliminate this risk.
This is also known as residual, specific or diversifiable risk pertains to a particular company or industry and includes incidents such as strikes, management change, legal action and other similar events. Unsystematic risk can be diversified by other investments in your portfolio to a certain extent.
It relates to the inability of a borrower to pay the contractual interest or principal on its debt obligations. This type of risk typically concerns investors who hold bonds in their portfolios.
It can be summarised as the uncertainties and hazards a company faces in its daily activities within a given sector or industry. The cause of operational risk is largely a breakdown in internal procedures, manpower and/or systems.
This occurs when the company is unable to meet its short-term financial demands. The reason for this is usually the inability to convert a security or asset to cash without a loss of capital and/or income in the process.
Understanding the risk/reward ratio
The risk/reward ratio is used to assess the profit potential of a trade relative to its loss potential, and is vital for its successful execution. The risk/reward ratio states that the value of the profit (or reward) for every trade must be at least three times greater than the value of the risk taken. For example, if you expect to make a profit of Rs 3 per share in a trade, you can risk a maximum value of Rs 1 per share.
Implementing the risk-reward strategy
At the onset, both the risk and potential profit of a trade must be decided upon prior to its execution. Risk is determined with the use of a stop-loss order, where it (risk) is the price difference between the entry point of the trade and the stop-loss order. The profit target is used to create an exit point in the event that the trade moves favourably. The potential profit is the price difference between the profit target and the entry price. Here, a stop-loss order is an order placed with a broker to buy or sell once the stock reaches a certain price.
If a trader buys a share at Rs 25.60, places a stop loss at Rs 25.50 and a profit target at Rs 25.85, then the risk on the trade is 10 paise (Rs 25.60 – Rs 25.50) and the profit potential is 25 paise (Rs 25.85 – Rs 25.60).
The risk/reward ratio is then decided upon by comparing the risk to the profit potential, i.e. 10 paise/25 paise = 0.4. If the ratio is greater than 1, the risk is greater than the profit potential of the trade, and vice versa.
How to manage market risk
There is a definite need to incorporate risk management practices to prevent large losses in the stock market. Having a premeditated and objective approach, with the use of stop-loss orders, profit-taking and hedging are imperatives in the process of managing market risk.
Another vital aspect in the risk management process is the understanding of the investors’ risk profiles – i.e., their ability to withstand risk – and building their portfolios accordingly. The investors’ personalities, lifestyle and age are parameters that have to be taken into account while deciding on their risk profiles.
Using portfolio diversification for Market risk management
Diversification is a strategy wherein risk is reduced by investing in a number of financial instruments, various companies and industries, and other categories. It aims to reduce risk and maximise returns by investing in this manner, as each financial instrument would react differently to the same event.
Risk management – the process of identifying and assessing risk and adopting strategies to manage and minimise it while maximising returns – is essential for anyone who is or plans to be proactive in the stock market going forward.
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