A beginner’s guide to risk management
What is risk management?
We manage risk throughout our lives, whether in everyday life (like driving a car) or when signing up for a new insurance or health plan. Risk management is all about assessing and controlling risk.
Most people manage risk unconsciously in their daily lives. But when it comes to financial markets and business operations, assessing risk becomes a very important and prudent practice.
In finance, we use a framework for how companies or investors deal with financial risk to describe the risk management measures that exist in various industries.
For traders and investors, this framework may include the management of multiple assets such as cryptocurrencies, forex trading, commodities, stocks, indices, and real estate.
There are many different types of financial risks that can be categorized in different ways. This article only provides an overview of the risk management process.
It also provides risk management strategies to help traders and investors mitigate financial risks.
How risk management works
Generally speaking, the risk management process consists of five steps: setting goals, identifying risks, risk assessment, risk control, and risk monitoring. However, these steps can vary greatly depending on the situation.
Setting goals
The first step is to define the main goals. It is usually related to the risk tolerance of a company or individual. In other words, how much risk they are able to take to achieve their goals.
Identify Risk
The second step involves detecting and defining potential risks. This step aims to identify various risk events that could lead to negative consequences. In business activities, this step can also identify other information that is not directly related to financial risks.
Risk Assessment
After identifying the risk, the next step is to assess its probability of occurrence and the severity of the consequences. Then, the risks are ranked in order of importance, which helps to create or take appropriate risk controls.
Risk Control
The fourth step is to define corresponding control measures for each risk based on its importance level. It determines the measures to be taken when a risk event occurs.
Risk Monitoring
The last step of the risk management strategy is to monitor the effectiveness of risk controls. This usually requires continuous collection and analysis of relevant data.
Financial Risk Management
In financial trading scenarios, there are many reasons why strategies or trading settings may become risky. For example, traders may suffer losses because the market goes against their futures contract positions or because of emotions, and eventually panic and sell assets.
Emotional outbursts often cause traders to ignore or abandon their initially set strategies. This is especially true during bear markets and market downturns.
In the financial markets, most people agree that having a proper risk management strategy can greatly contribute to trading success. In reality, risk management can be as simple as setting a stop-loss or take-profit order.
A robust trading strategy should provide clear and controllable risk management measures, which means that traders can more adequately respond to various unexpected situations. As mentioned earlier, although there are many ways to manage risk. Ideally, risk management strategies should be constantly modified and adjusted according to actual conditions.
Below are some examples of financial risk management and a brief overview of how to mitigate risk.
Market risk: This can be minimized by setting a stop-loss order on each trade, which can automatically close a position before a significant loss is incurred.
Liquidity risk: This risk can be mitigated by trading in mainstream markets. Generally, assets with high market capitalizations tend to be more liquid.
Credit risk: Credit risk can be reduced by trading on a trusted exchange, so that borrowers and lenders (or buyers and sellers) do not need to trust each other.
Operational risk: Investors can mitigate operational risk by diversifying their portfolios, not putting all their eggs in one cage, and avoiding investing in a single project or company. To avoid operational risk, investors usually do some research and look for companies with low operational risk.
Systematic risk: It can also be reduced by diversifying the portfolio. But more often, diversified investments should at least be companies from different industries or projects that are clearly different. It is best if the projects invested in show very low correlation.
Summary
Before opening a trading position or allocating funds to a portfolio, traders and investors should consider developing a risk management strategy. However, it is important to remember that financial risks cannot be completely avoided.
In general, risk management defines the way of dealing with risks, which includes not only how to mitigate risks. It should also be strategic thinking in order to mitigate inevitable risks in the most effective way.
In other words, risk management should include risk identification, risk assessment and risk monitoring. The risk management process aims to evaluate the risk/reward ratio so that investors can find the most profitable position trading.
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