Trader’s Guide 2.4- Risks
As investors and traders, it is crucial to understand and manage the various types of risk that can impact our portfolio. These risks can come in many forms, but some of the most common types include market risk, credit risk, and liquidity risk. In this chapter, we will delve into each of these risks and explore how they can affect our investments. We'll also look at a real-life example of how proper risk management can help to mitigate the impact of these risks, as well as some additional types of risk that investors should be aware of, including correlation risk, liquidity risk, and counterparty risk.
First, let's define each of these types of risk. Market risk, also known as systematic risk, refers to the inherent risk present in the overall market. This type of risk cannot be diversified away, as it affects all investments in the market to some degree. Examples of market risk include economic downturns, natural disasters, and geopolitical events.
Credit risk, on the other hand, is the risk that a borrower will default on their debt obligations. This type of risk is most commonly associated with bond investments, as bondholders are owed interest and principal payments by the borrower. However, credit risk can also be present in other types of investments, such as loans made to small businesses or real estate developments.
Liquidity risk refers to the risk that an investor will not be able to sell their investment when they want to or at a price they are willing to accept. This can occur when there are not enough buyers for a particular asset, or when the market is experiencing significant volatility. Liquidity risk is a concern for all investors, but it can be especially problematic for those with large or illiquid holdings.
Correlation risk is the risk that the returns of two investments are correlated, meaning that they tend to move in the same direction. This can be a problem for investors who are trying to diversify their portfolio, as correlated investments may not provide the desired level of diversification. For example, if an investor holds both US and European stocks, they may be exposed to correlation risk if the two markets tend to move in tandem.
Counterparty risk refers to the risk that the other party in a financial transaction will not fulfill their obligations. This type of risk is particularly relevant in the world of derivatives, where investors may be exposed to the creditworthiness of the counterparty. For example, if an investor enters into a futures contract with a counterparty and the counterparty defaults on their obligations, the investor may suffer a financial loss.
Now that we have a basic understanding of these types of risk, let's look at a real-life example of how proper risk management can help to mitigate their impact.
Imagine that you are an investor in a large, diversified portfolio. Your portfolio consists of stocks, bonds, and cash, and you have taken care to diversify across different sectors and geographies. You have also conducted thorough due diligence on each of your investments to ensure that you are comfortable with the level of risk involved.
One day, you receive some unsettling news: there has been a major terrorist attack in a major city, and the stock market is plummeting as a result. Your portfolio takes a hit, as many of your stocks are down significantly in value. However, you remain calm and do not panic sell, as you know that market fluctuations are a normal part of investing.
As the days go by, the market continues to decline, and you start to worry about the potential impact on your portfolio. You decide to review your holdings to see if there are any areas of excessive risk. You notice that you have a significant allocation to the energy sector, which has been particularly hard hit by the market downturn. You also have a number of bonds from companies in the retail sector, which has been struggling in recent years due to the rise of e-commerce.
After careful consideration, you decide to sell some of your energy stocks and use the proceeds to diversify into other sectors. You also decide to sell some of your retail bonds and invest the proceeds in a more diversified bond fund. By taking these steps, you are able to mitigate the impact of market risk and credit risk on your portfolio, as you have reduced your exposure to sectors that have been disproportionately affected by the market downturn.
In addition to market and credit risk, you also need to be aware of liquidity risk in your portfolio. You realize that you have a large holding in a small-cap stock that is not very liquid. While you still believe in the long-term potential of the company, you decide to sell a portion of your holding and use the proceeds to invest in more liquid assets. This helps to ensure that you will be able to sell your investments if you need to in the future.
You also review your portfolio for correlation risk. You notice that you have a significant allocation to both US and European stocks, and you are concerned that the two markets may be correlated. To mitigate this risk, you decide to sell some of your European stocks and invest the proceeds in emerging markets, which have a lower correlation to the US market.
Finally, you consider counterparty risk in your portfolio. You have a number of derivatives contracts, and you want to make sure that you are not overly exposed to any one counterparty. You review the creditworthiness of your counterparties and diversify your contracts across a number of different parties. By taking these steps, you are able to reduce your exposure to counterparty risk and protect your portfolio against potential defaults.
Overall, proper risk management is key to a successful investing strategy. By being aware of the different types of risk and taking steps to mitigate their impact, you can help to protect your portfolio and achieve your financial goals. While there will always be uncertainty in the markets, by following a disciplined approach and staying informed, you can navigate through even the most challenging situations.
