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TYPES OF INVESTING AND TRADING RISKS

However well prepared the trader or investor is, with all trades and investments there will be risks. The risks present themselves in various forms that can impact trades and investments. From broader  politically related risks to individual business risks, some risks are inevitable. As a trader or investor you will want to know these differing types of risk and how they can impact your trades and investments. Preparation and research is key and should be detailed and extensive.

The different types of risks

  • An analysis of the various risk types and their effects on funds and stocks
  • Mitigating and preparing for risks
  • Learning from the risks and how to protect your funds

Steve Miley

pro MEMBER SINCE 2018

Steve has 29 years of financial market experience including 3 years at Credit Suisse and 15 years at Merril Lynch. Steve is the Academic Dean for The London School of Wealth Management and has won many awards from Technical Analyst Magazine.

10 min read 26th of Jun, 2018
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How to Recognise Risks

There are different risks when investing and/ or trading, whether you’re looking at stocks, bonds or commodity markets. Unfortunately, many of these risks are largely out of your control, and the best you can do is put measures in place to understand the risks and be able to deal with them should they arise. There will always be market volatility as changes occur in geopolitics and the outlook for the economy. Wherever possible, when making investment decisions, potential risks should be accounted for. Although risks can cause losses, it is important to remember that without some risks it would be more difficult to achieve successful returns on investments. It is the systematic risks inherent in markets that drive price action and then provide opportunities for profits (and of course losses).

TYPES OF INVESTING AND TRADING RISKS

Risks are, therefore, the potential bumps in the road that traders and investors encounter while trading and investing that could affect profitability. They can impact the financial markets and your overall capital and investment funds. One obvious way of being able to closely monitor these risks is to actively manage investment funds yourself. This allows you to potentially foresee the risks and understand their potential impacts. While you research and identify these risks, it’s also important to remember that some risks may impact the entire stock market, whilst others possibly just impact  sectors and industries, or individual stocks.

The common broader, systematic risks include:

  • Changing interest rates
  • Recessionary pressures
  • Inflation

Business, Credit and Interest Rate Risks

Business risk is the potential that a company issuing shares will either experience a significant financial loss or go completely bankrupt. This risk is an unsystematic risk, which means it is connected to a specific security. A way of avoiding this risk is by diversifying and investing in mutual funds, where the investment is spread across different companies. Closely monitoring individual businesses progress and results can also give you a good indication of the expected future risks.

A credit risk refers to the possible situation where a company or bond issuer will be unable to pay the necessary interest rate and principles payments on their debt. Again, by monitoring individual businesses results and credit ratings and reports, possible future risks can be somewhat accounted for.

Changes in interest rates can impact your investment. Bonds are particularly sensitive to changes in (or expected changes in) interest rates. Stocks are also exposed to this interest rate risk, with some sectors more susceptible than others (particularly the banking and financial sectors).

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Market, Currency and Dividend Risks

Market risk is what would be classified as a systematic risk, meaning it poses risks to countries and industries in general, not just one area specifically, and at any one point in time is often caused by a specific, distinguishable factor.

One of the major risks for funds and stocks is the changing currency or exchange rate. Because each stock is priced in a currency, investing in overseas stocks will require a currency exchange. This poses a risk because the exchange rate could impact your returns. Also, if a company earns a large percentage of their revenue from overseas enterprises in overseas currency, there is a foreign exchange risk, as these revenues will need to be converted back to the companies own domestic currency.

Traders who rely largely on the profits of stock dividends will have to be wary of companies that for some reason may decide to reduce their dividend payouts. If this occurs, your investment will lose a significant part of its income and profits. And when a company reduces its dividends, the stock also runs the risk of decreasing in value.

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Geopolitical and Liquidity Risks

The state of a nation as a whole can be seen as a wider source of risks in trading and investments. Any changes or alterations made due to political figures or negative/uncertain political events can impact a variety of stocks and investments. The political aspect is not the only one to consider in this respect. Social changes and legal decisions can all impact stocks.

Liquidity risks for a company is the ability to pay debts and/ or costs without suffering significant losses. However, for trader or investor liquidity risk refers to the situation when it is not easy to quickly enter or exit trades. This can be due to heightened market volatility, often resulting in a widening of the bid-offer spread. However, some markets are naturally less liquid that’s others, where the bid-offer spread is always wider than more liquid markets. These markets threaten heightened liquidity risks.

How to Recognise Risks

Risk Prevention and Future Preparation

A number of trading strategies can be implemented in every aspect of trading to help ease the effects of major or minor risks.

  • Thorough research
  • Asset allocation
  • Diversification
  • Equally dividing funds

No investor should begin his or her journey without conducting thorough and detailed research. Although many things can be learnt through the experience of trading itself, it is wise to educate oneself on all aspects of trading. This gives the trader or investor the advantage of knowing what the risks are of trading or investing in various financial market assets and to try to identify them in advance.

Asset allocation refers to having a variety of assets in your investment portfolio, rather than limiting it to one asset class alone.

The reason this can prevent the consequences of risks, or at least relieve them, is because with more diversification of assets, you have better chances of profitable returns. Of course, your assets should be suitable for your portfolio, but a variety of assets can help to ease possible negative impacts.

When you diversify your investment portfolio, you share your funds across the various financial markets assets you are trading/ investing in. For example, if you have five different stock investments, you could allocate 20% of your total funds to each stock. This way, if only one stock falls, the majority of your funds will remain safe in the other stocks.

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Conclusion:

A Summary of What you Need to Know

Whether you are a beginner trader or have some experience, you can never be too prepared for potential risks. The unfortunate truth is that risks inherent in markets can make or break your investments, but they don’t necessarily have to do the latter. Your first step to avoid potential damage is to know how the various potential risks might impact your investments and how to recognise them. In order to do this, you will require a good understanding of the various risks associated with differing financial market assets, such as business, political, market and currency risks. There are numerous risks and when you add them all up, there are quite a few to be prepared for.

By educating yourself, you are already on your way. Various measures, such as conducting thorough research and diversifying your investment portfolio can mitigate investing risks. Once you have covered these aspects, you can be more confident in your trades and investments, and can continue trading with the peace of mind that you are as prepared as you can be for whatever comes your way. Happy trading!

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