It’s a risky world out there.
No, I am not trying to scare you at all. But then, a smart individual is the one that acknowledges this fact and prepares for it. Rather than running away from the truth. We live in a highly uncertain macroeconomic environment. In the past three years, we saw the surge of Covid; Stock and Crypto markets hitting an all-time high and later dipping like there’s no tomorrow.
Some of the brightest investors in the world agree that investing and trading is simply a game of managing risk well. So next time, if someone claims that they can predict the market movement and hence need not plan for the downside, make sure that you maintain your distance.
But what is a risk management strategy, after all? What kind of risks does it cover? Is it really, really important to have one? Well, you are about to find that out. Lets’ go!
Risk Management Strategy – An Overview
Risk management is a structured process of identifying, mitigating, and accepting uncertainties in your investments. Now, most people think that risk management is a documented plan stored in a pile of documents that can be referred to whenever risk approaches. However, the reality is that risk management is a cyclical, ongoing process for all investors. All the risks are identified, assessed, managed, and monitored using this strategy on a periodic basis. Let us see what each of these steps means.
1. Identification of risks
One of the key factors in the identification of risks is to set up controls and tools in the system that would raise a red flag in case of an anomaly. For example, when banks fund your loans, they often run a credit check. From an investor’s perspective, understanding the background of your assets is a key form of risk identification. This involves constant monitoring of news and changes in the business landscape of the crypto/stocks you have invested in.
The entire thesis of identification is to be proactive rather than reactive when it comes to risks.
2. Assessing risks
Not all battles are supposed to be fought. After the identification of the risks, investors often line them up in the order of severity and impact. This is usually done by creating a 2×2 matrix with severity and impact. This activity helps investors to prioritize these risks and tackle them sequentially rather than parallelly.
This often helps investors separate noise from the market. A smart investor would understand the severity of the risk and take action only on the triggers which impact their long-term view of the companies. For example, people who would have sold in the initial days of Covid when markets crashed would have missed the opportunity of making lifetime returns due to epic V-shape recovery and all-time highs. While covid was a big threat, looking beyond it to understand if the fundamentals of the business are impacted or not is what assessment is all about.
3. Response
Now that you have identified and prioritized your risks, it is time to respond to them as per the action plan created. This involves the implementation of controls and measures that are meant to tackle the risks on a timely basis.
4. Monitoring risks
It is very important to monitor the systems and processes laid down for risk management. Revisiting your risk management strategy on a timely basis keeps it up-to-date and also decreases the response time, which can be a game changer in case of high-impact severe risks.
In essence, it is suggested not to leave your portfolio in auto mode for long but quickly understand and reevaluate the situation to make bets accordingly.
Importance of Having a Risk Management Strategy
A short answer would be that risks are inseparable from return. While I am not suggesting you go full-degen, double or nothing mode. But then, an optimum risk as per one’s appetite is required for investing. For example, people believe that bank FDs are safe. But then, for the banks that went under in the previous year (PMS bank/Yes Bank) had to stop honoring FDs momentarily for their customers until the government intervened and rescued them.
Similarly, debt funds are considered a safe haven for parking money, but then some of the Franklin Templeton funds stopped withdrawals for 12-18 months, citing Covid.
Just think about it for once. Do you have any business in mind that has no risk involved whatsoever? Even the biggest companies in the world, like Meta and Google, constantly face threats due to changing regulations and customer expectations. Therefore, having a well-thought-through risk management strategy with a SWOT (Strength, Weakness, Opportunity, Threat) analysis is extremely important. Following are a few other benefits of having a risk management strategy.
1. Efficiency and continuity
Robert Herjavec, the famous Shark Tank investor, once mentioned during a pitch that we often assume that doing business is a smooth road to glory. However, often ‘poop happens.’ Given the experience of this gentleman in running businesses and investing, it is safe to assume that risks can pose a direct threat to operational efficiency and business continuity.
Similarly, an investor also needs to stay solvent in order to stay alive in the market. And this solvency is a function of efficient risk management.
2. Protection of your assets
Going bust has never helped any investor. Of course, there are lows that test your guts, but then in order to come out of it, you still need to have your assets backing you up.
Once, a famous economist, John Maynard, said, “Markets can stay irrational longer than you can stay solvent”
Therefore, if you are going in with an invincible mindset, markets can shake your confidence pretty soon. So it is always smart to have a risk management strategy.
3. Increased profitability
You can’t win on each one of your bets. Even the best traders and investors in the world couldn’t do that. Therefore, the best you can do is a hedge against your risks and try to generate a decent return using risk management strategies.
While it may initially feel that these tactics are limiting your upside but then, in the long run, they help you to increase your profitability.
This involves understanding your win-loss ratio and the average size of your wins and losses. If you know these numbers, and they add up to long-term profitability, you are well on your way to successful trading. If you don’t know those numbers, you are putting your trading account at risk.
What are the Four Common Risk Responses?
Now that we have figured out the importance of having a risk management strategy let us try to dive deeper into the common responses. Although these responses would have a spin-off based on the risk appetite of the investor, they can still be categorized into the below general categories.
1. Avoiding risk
Prevention is better than cure? Well, avoiding risk is a strategy that can be deployed to the low severity, low impact risks. Also, one should always keep in mind that if these types of risks emerge consistently, they can’t be avoided each time.
For example, recently, there was a lot of noise in the market around the liquidity issues of Binance– the world’s largest cryptocurrency exchange. Now everyone knows that it is really hard for Binance to be insolvent. After all, their reserves run in billions. Therefore, it is safe not to change tracks. This is a classic example of avoiding risk by identifying it as a low impact and low severity.
2. Accepting risks
When avoidance is not a feasible response to a risk, it is better to accept it. When a risk is unlikely to occur or has a low response, it is often better to act on it.
Let’s take a similar example as quoted above. In this case, I removed my assets from Binance and squared off my positions in BNB (the native token of Binance). My net worth wouldn’t have been impacted as Binance is still alive and working fine today. But then, why take a chance if you can accept risks altogether?
3. Mitigating risks
Mitigation of risk is a very popular response to risk management. Although it could be the best approach in case of significant risks as compared to acceptance or avoidance, then, it is not always feasible. This response involves identifying the risk, assessing all possible solutions, devising a plan, taking action, and monitoring the results.
4. Transferring risks
There are situations in every business when avoiding, accepting, or mitigating risks is just not possible. These risks are comparatively bigger and have a high impact. In such cases, it is better to outsource the risk.
Hedging is a way to transfer risk. Traders often use hedging to protect against risks when liquidating their trading position would be difficult or impossible.
5 Major Risk Management Strategies to Follow
Ready to tackle the risks? Not so soon. Let us figure out some of the key strategies that can help you do the same.
1. Minimizing losses
While it sounds pretty intuitive, it is easier said than done. For a professional trader, it is always advisable not to lose more than 1% of his portfolio in a single trade. This is because losses can compound easily over time. For example, to recover a loss of 10%, you need to make returns to the tune of 11.1%. However, to recover a loss of 50%, you simply need to double your money.
One key strategy to implement this would be putting up stop losses where your holdings are sold automatically as a pre-decided price point hits.
Some advanced traders also use something called a trailing stop-loss. This means that the level of stop-loss keeps on going up as the crypto moves upward to help you secure your profits at a higher level if the crypto were to go down.
2. Separating emotions
Currently, Berkshire Hathaway releases their holding statement once a quarter. But then, none of us became a millionaire by simply copying it. That’s not because we don’t have real-time updates but also because we cannot separate our emotions from our investment strategy.
We often fall prey to FOMO or a FUD before we buy or sell cryptocurrency.
The need of the hour is to lay down a clear plan and strategy that will go behind choosing, buying, and selling a cryptocurrency. If this criterion is fulfilled, then only take a call on changing your portfolio, or else ignore all sorts of emotions.
Remember, volatility is the cost of holding!
3. Diversification
Diversification is the holy grail of investing. Therefore, one should aim to diversify within the asset classes and also between the sectors they are investing in. For example, a good portfolio would have a decent mix of fixed debt assets and equity/cryptocurrency.
Even within the crypto asset class, one should diversify in sectors like Metaverse, NFTs, DeFi, Layer 1 solutions, etc. Coin Sets by Mudrex can help you pick all the cryptos belonging to a particular sector with a click of a button.
4. Insurance
Just like insurance would protect your vehicle against damages, financial markets do offer products that can safeguard your capital in case of a downturn in events.
In financial markets, credit default swaps (CDS) operate similarly, whereby one financial institution receives premium payments to insure another financial institution against a credit event in some other company or investment. Risk avoidance is another mitigation strategy that tries to prevent being exposed to a risk scenario completely.
5. Data analysis
Data speaks the real story. Beyond all hypotheses, data-driven decisions usually prove to be the real game changer. Conducting a thorough qualitative risk analysis helps to isolate and prioritize risks and to develop strategies to address, monitor, and re-evaluate them.
There are multiple platforms out there that allow traders and investors to try out their strategies through paper trading. This is a form of trading/investing where money isn’t involved.
Conclusion
Effectively managing risk has always been critical for the success of any investor— but never more so than today. This is because the uncertainty the world has dealt with in the past couple of years is unique and unparalleled. Some of the biggest organizations have stopped presenting 5-year plans and have stuck to a 1-year plan because of this.
Being able to identify and properly assess risks reduces missteps and saves money, and time, which are two of the most valuable resources for any investor.
So, if you are an individual searching for your next big bet, take it with a pinch of salt and plan for the downside as well. For if you knew the direction of the asset with 100% certainty, you might not have been reading this.
FAQs
1. Why is risk management important?
Risk management is important for an investor and traders to make sure that they maximize their returns and minimize their losses. These strategies help them to safeguard their capital and plan for the worse, just in case. Apart from that, in the long run, risk management helps you build your portfolio strongly and hence increases profitability as well.
2. Who is responsible for risk management?
While the platforms involved in investing hold some level of accountability in terms of protecting your assets from hacks and other security concerns, for the remainder of the part, investors and traders are themselves solely responsible for their risk management. This is because they have the most skin in the game.
3. How does risk management create value?
Risk management can create value by saving costs of compounded losses in case of no risk management. Apart from that, when the best risk managers in the world generate the best consistent returns. Consistent is the keyword here. Simply because it is easy to hit the moon once or twice, but then the investor who does it constantly is the real winner.
