Understanding market risk is crucial in devising effective risk management strategies. How can we better assess and manage these risks, and what strategies can we employ to mitigate them?
Over the past two blogs, I've delved into the complexities of our current economic landscape and the factors driving it. But why do we need to navigate these complexities? The answer lies in risk mitigation. It's a crucial aspect that often gets overlooked. Many assume my wealth is solely derived from real estate because my professional career revolves around real estate, but that's not the full story. Risk mitigation, a strategy I've personally employed, has played a significant role in my financial journey. It's a testament to the power of effective risk management in achieving financial success.
You can follow the example of other investors and analysts who often use the value-at-risk (VaR) method to measure market risk. VaR modeling is a statistical risk management method that quantifies a stock or a portfolio’s potential loss and the probability of that potential loss occurring. While well-known and widely used, the VaR method requires certain assumptions that limit its precision.
However, it's important to note that VaR, while a widely used method, has its limitations. It assumes that the content of the measured portfolio remains unchanged over a specified period. While this may be acceptable for short-term horizons, it may not provide the most accurate measurements for long-term investments. As a long-term, younger investor, I've found that this method may not always be the best fit. It's crucial to be aware of these limitations and consider them when making investment decisions.
For all my stock enthusiasts, it is essential to note that the Securities and Exchange Commission (SEC) requires publicly traded companies in the United States to disclose how their productivity and results may be linked to the performance of the financial markets. This requirement details a company’s exposure to financial risk. This information helps investors and traders decide based on their risk management rules and is a good resource for determining short-term and long-term risks.
I believe market and unsystematic risks are the two major investment risk categories. Market risk, or systematic risk, cannot be eliminated through diversification, though it can be hedged in other ways. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters, and terrorist attacks. Systematic or market risk tends to influence the entire market simultaneously.
This can be contrasted with unsystematic risk, which is unique to a specific company or industry. Diversification can reduce unsystematic risk.
Market risk exists because of price changes. The standard deviation of changes in the prices of stocks, currencies, or commodities is called price volatility. Volatility is often presented in annualized terms and may be expressed as an absolute number, such as $10, or a percentage of the initial value, such as 10%.
In contrast to the market’s overall risk, the specific risk of unsystematic risk is tied directly to the performance of a particular security. It can be protected against through investment diversification.
One example of unsystematic risk is a company declaring bankruptcy, making its stock worthless to investors.
The most common market risk types include interest, equity, currency, and commodity risks, which we discussed in a previous blog – How Do Financial Markets Function?
Interest rate risk covers the volatility that may accompany interest rate fluctuations due to fundamental factors, such as central bank announcements related to changes in monetary policy. This risk is most relevant to investments in fixed-income securities, such as bonds.
Equity risk is the risk involved in the changing prices of stock investments.
Commodity risk covers the changing prices of commodities such as crude oil and corn.
Currency risk, or exchange rate risk, arises from the change in the price of one currency to another. Investors of firms holding assets in another country are subject to currency risk.
Going back to my stock enthusiasts for a minute, if you are investing, there is no way to avoid market risk altogether. However, you can use hedging strategies to protect against volatility and minimize the impact that market risk will have on your investments and overall financial health. For example, when targeting specific securities, you can buy put options to protect against a downside move. Or, if you want to hedge an extensive portfolio of stocks, you can utilize index options.
You may have heard of dollar-cost averaging, and while it will not protect you against market risk, investing the same amount of money on a regular schedule can help you ride out market ups and downs, taking advantage of periods of low costs and high returns.
To manage interest rate risk, pay attention to monetary policy and be prepared to shift your investments to account for interest rate changes. For example, if you are heavily invested in bonds and interest rates are rising, you may want to tweak your investments to focus on shorter-term bonds.
When markets are volatile, you may have trouble selling or buying an asset within your price range, especially when you need to exit a position quickly. If the market crashes, liquidity may be difficult no matter what type of stocks you buy. Under more normal conditions, you can maintain your liquidity by sticking with stocks that have low impact costs to make trading easier.
No matter where you invest your money, it is impossible to escape market risk and volatility entirely. However, using a long-term investing strategy, you can manage this risk and escape much of the impact of volatile markets. You may want to make minor tweaks in response to changes in the market. But don’t upend your entire investing strategy because of a recession hit or a currency change in value.
In general, short-term traders are more impacted by volatility. By contrast, volatility tends to even out over time. By approaching your investing systemically and sticking with a long-term outlook and strategy, you are more likely to see your portfolio bounce back from the impact of market risks.
The bottom line is that market risk is the chance of incurring a loss due to factors that affect the overall performance of financial markets. Stay on top of events, don’t freak out, make small movements.
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