How to manage financial risk


One of the largest topics when investing is dealing with financial risks. Investors, before and during their investment, need to determine if the rewards of their purchased assets outweigh the risks.

Thinking about how much you can lose, before how much you can win, will put the risk and the reward into the right perspective. If you know the risks, you can put contingency plans in place, monitor the situation, and take appropriate actions.

How can you manage financial risk?

  • Think rationally about what could go wrong.
  • Don’t ignore macro- and sector level analysis.
  • Choose a regulated and safe broker.
  • Diversify appropriately.
  • Invest in uncorrelated assets.

Want to learn more? Read on…


What is the definition of risk?

Risk is a chance of any hazard causing you harm. You could also say that is risk consists of:

  • A threat (the source of the risk that didn’t occur yet).
  • An event under which the threat can occur.
  • The probability of the event occurring.
  • The impact or consequence if the event occurs.

Let’s assume you want to cross a street with much traffic. Cars are driving fast. The next underpass to cross the road safely is within 15 minutes, walking distance. As you don’t want to take a lengthy walk, you assess if it is worth taking the risk to cross the street where you are.

  • The risk or threat is that you could get hit by a car.
  • The event that triggers the threat is when you cross the street.
  • The impact is that you could be severely injured or even worse.
  • The reward is that you’ve saved 15 minutes of your time.

The visibility is good, and you see cars coming from far away. The drivers also see you, the chance is high that they will reduce speed.

There are some gaps in between the driving cars. It takes cars around 30 seconds from when you see them until they reach your spot. If you run, it will take you around 10 seconds to cross the street. So, you have a 20-second buffer.

You assess that the probability that you will get hit by a car is low and decide to take the risk to cross the street and save the 15 minutes.

Let’s assume you are in the same situation, but your child is with you. Your child might be scared and react in the wrong way. The probability that something unforeseen happens is more significant than before. So, you decide to take precautionary measures and walk the 15 minutes to the next underpass.

We take many such assessments daily without the word “Risk Management” in our heads. We learned to assess these risks since Kindergarten. You might remember that when you were a kid you were guided by police officers that came to school to learn how to cross the street. We were taught by people, how to deal with these risks. On other occasions, we learned it the hard way by ignoring the risks and facing the consequences.


What are the main risk management strategies?

If we look at Risk Management from a general perspective, there are four main ways to deal with risks.

  • Avoid it
  • Reduce it
  • Transfer it
  • Accept it

Avoid it

You can decide to not invest and keep your money in a savings account or storing it at home.

But “no risk” also means “no reward.” The interest rate you get when you keep the money on a savings account is meager. Similarly, when you store your money at home, you won’t earn any interest at all.

Depending on the inflation rate, your money can lose value over time, because the costs of goods and services might increase.

Reduce it

How can you reduce investment risks?

You can educate yourself so that you have a good understanding of risks in relation to the rewards. You can learn how to take educated decisions.

You can diversify your investments. Instead of purchasing shares of only one company, you can buy shares of many companies. If you bought for example all companies in the S&P 500 index, you bought 500 of the biggest companies in the US. The chance of any of them failing is very low, and even if one does, the other 499 are still doing well.

If the share prices are high there might be a correction at some point, but the stock prices could also increase further. You could cost average and buy the same amount of shares on a monthly basis, so that sometimes you will buy at a lower price, and sometimes at a higher price, which will smoothen out potential losses.

You could put some money into a hedge fund that will invest into assets that are uncorrelated to the stock market.

You could invest in assets in different currencies, to prevent currency risk. If the US Dollar falls, the Yen might rise.

You could buy an options contract in the opposite direction you invest in, that you can use if the stock price falls instead of increases.

Transfer it

You could transfer the risk to someone else. But here we have to differentiate between transferring the financial decision and transferring the financial risk.

Most of the investment firms will happily help you with the decision process, but they will not take the financial risk. If their predictions were wrong, they will not cover your losses.

However, there are certain investment products, offered by insurance companies, that offer some protection. An insurer might offer you a fund combined with insurance that guarantees that you can’t lose more than 25% of your invested capital. If the fund fails and tanks over 25%, then the insurer will cover the loss up to 75% of your invested capital. This guarantee, however, comes with a price. Either you will have to pay a premium, or your profit will be capped at a certain level.

Let’s assume that you’ve invested in an insurance fund with 75% coverage of your investment in case of a loss, capped at 3% in profits, and the stock price went up 8% over the year. This means that you gain 3% on your invested capital, and the insurer gains 5% on your invested capital. If you had invested in the fund, without insurance, you would have gained 8%. But if the mutual fund would have gone to negative 30% that year, the insurer would have covered the 5% in additional losses if you would have decided to pull out your money.

But what if the insurance company goes bankrupt? Usually, the mutual fund assets are held separate from the company assets, so if the insurer goes bankrupt in this setup, then you won’t lose your assets. This is something you will need to take into consideration as part of your risk analysis before purchase.

Accept it

You can accept the risks, trust your risk analysis skills, and have contingency plans in place if any of the risks should materialize.

Turn risks into opportunities

A risk can sometimes also be turned into an opportunity. Suppose a country has been in political turmoil but starts to recover with a reliable government, low dept, and promising future outlook. In that case, it might make sense to invest, as the prices are still low. Many investors might wait a little longer before they invest, and this is your opportunity.

If the country is turning from an emerging economy into a booming economy, and you bought cheap, you’ll turn a higher profit, than the ones that invested later.

Summary

We have learned that life comes with risks, and this includes financial risks. We need to identify these risks by thinking about potential threats, which events can trigger these threats, the likelihood of them occurring, and how we react to them.

There are different strategies to deal with risks, that include avoiding risks, reducing risks, transferring risks, or accepting risks. All these strategies have their pros and cons, and it will be up to you to determine which strategy is best for you.

Financial institutions have a lot of experience with risk management, and hence they offer less risky products to investors. They usually also have the time can capital to recover more easily from such losses. But investors will have to pay a premium for such products, which will limit their profits. The premium is usually paid in fees or capped returns.

As more you learn about the risks of investing, the more tolerant you’ll get to expose yourself to the risks and have mitigation plans in place, which you can action when risks materialize.

Risks can also be turned into opportunities, because other investors might not be as risk tolerant as others.


How to assess financial risks

One of the rules that Warren Buffet once stated was:

  1. Rule number 1: Never lose money.
  2. Rule number 2: Never forget rule number 1.

Financial Risk Management is all about minimizing potential losses. Investors usually do that by analyzing the companies they invest in, but should also take macroeconomic developments into consideration.

Investors will usually build up a portfolio of different financial assets based on their risk appetite. As an example, an investor could build a portfolio that invests 75% in large-cap companies, with very solid financials and 25% into small-cap companies with less solid financials. Small-cap companies tend to grow fast, as they are usually very innovative, but the risk of bankruptcy is higher, as the companies might not be profitable yet. Large-cap companies tend to be solid institutions that grow slower, but the profit is usually more predictable. By creating a portfolio with different kinds of risk levels, some riskier positions which will be a bonus, to the rather conservative investments, an investor might have the chance to gain more investment returns, without putting all his money at high risk. Another option is to mix the portfolio with different kinds of assets such as a percentage of stocks, bonds, and real estate.

Investors should also be concerned with macro-economics. Countries with turmoil and political issues can’t focus on the production of goods and services, and this will lead to less profitable companies.

It is imperative that you think rationally. Not in terms of stock market price, but in terms of the contract you sign, the companies you purchase, the surrounding economic environment, and the risks you take, vs. the rewards you get.

Let’s assume you find a cheap villa. You look at the estate from the outside, and it looks stunning. You walk inside and see high finishing everywhere. Only the best materials used. You look at the villa and the land it’s built on from each angle, can’t find anything wrong with it, so you decide to purchase it. It was a good investment until the Volcano erupted that you’ve overlooked.

Let’s take a real example: one of my mistakes at the beginning of my investing journey. I’ve invested in a company in Argentina. The stock price was low, and the company had an enormous cash cushion and moat. A fantastic value investment and a great company.

A month later the stock tumbled, and it was only then that I noticed that Argentina was in a long-term recession, and there were ongoing elections which were won by the socialist and not the capitalist party. The stock price tanked heavily after the polls.

I was only looking at the company and its balance sheet during my analyzes. I didn’t look at the macroeconomics (the country, the fiscal and monetary policy, and so on), which I should have taken into consideration.

It was an excellent lesson, and these lessons will pay off big time for new investors. Think about the experience you’ll gain and what you’ll learn from it. I still own the stock. I have time to be patient. It was only a fraction of my full portfolio I’ve built over time. The fundamentals of the company itself didn’t change. Still a good business with a large cash cushion, interesting projects, and moat.

When you analyze the risks of your financial assets, you can either take a top-down or bottom-up approach.

If you have found a good company with fair valuation, then you can take the approach to analyze the company first, move to the sector, and then up to the country level.

On the other hand, you could also look at the countries first to determine which of them are stable with economic growth, and then work yourself down to the sectors and companies.

When you are new to financial analysis, try to keep it simple and don’t lose yourself too much in the macro-economic numbers. Usually, for your investments, it’s sufficient to get a sentiment of what’s going on. Macroeconomics is a tremendously exciting topic, and it’s something you’ll gain more experience with time.

Key indicators can change depending on the economic and financial environment, and others might become important. For example, in a worldwide pandemic, you wouldn’t want to invest in airlines. Governments might put policies in place and temporarily shut down certain businesses, which will limit economic growth. On the other hand, the FED might start printing money, which might positively impact publicly traded companies, as money is pumped into the stock market.

What are the macroeconomic risks?

The leading indicators of macro-economics are the national output measured in GDP (gross domestic product), unemployment rates, and interest rates.

Countries use fiscal policies and monetary policies to stabilize their economies. Fiscal policies are used to control the government’s spending. The central bank uses monetary policies to increase or decrease the money supply.

Macroeconomics is a very big topic in itself and even professionals get it wrong sometimes.

For my investments, I try to keep it simple. Below is a list of questions that I usually want to have answered to be informed about the risks.

How stable is the government?

  • Are there any conflicts between political parties?
  • Are there any conflicts with other countries?
  • Is there any social unrest?
  • What’s the level of corruption?
  • How high is the chance of a recession?

I try to get a sentiment if the country and the government is stable and if there are any indications of potential future issues.

When are the next elections?

  • Who are the parties that have the most considerable chance of winning?
  • What are their economic goals and which companies profit from these goals?

Elections can cause turmoil and the economic agenda will depend on the party that comes into power.

What are the fiscal policies?

  • Where is the government spending the money?
  • How much debt does the country have?
  • How high are the taxes for companies and individuals?
  • What’s the unemployment rate, and where will it go over the next year?

How is the government dealing with its finances? Who profits, and how productive is the country?

What are the monetary policies?

  • How is the currency doing against other currencies?
  • Will the currency appreciate or depreciate against other currencies?
  • What’s the inflation rate, of the country?
  • Is the interest rate expected to increase or decrease over the next year?

This gives an indication, which assets are best suited. If interest rates go up, it might be interesting to buy Bonds, if interest rates are low, then stocks might be better. If the inflation rate is high, and returns on investment are low, then it might not be worth the investment.

From where can you get the data?

Below some useful sites, that provide fundamental data:

What are the sector risks?

Sectors are divided up into four main categories:

  • Primary Sector: The primary sector is the oldest economic sector. It’s about production in its most traditional form, the extraction of raw materials. This sector includes agriculture, forestry, timber harvesting, hunting, fishing, and mining. An interesting fact is that there is an inverse correlation between the primary sector and a countries development. The lower the number of employees or companies in the primary sector, the more developed a country usually is. The primary sector is generally larger in developing countries, and smaller in industrialized countries.
  • Secondary Sector: The secondary sector processes the raw materials of the primary sector. These are mainly industrial companies such as manufacturing, construction, energy, and water supply companies. The secondary sector is also usually larger in developing countries. Developed countries tend to outsource the secondary sector abroad as it is more cost-effective.
  • Tertiary Sector: The tertiary sector comprises the services that are provided in a country. In contrast to the primary and the secondary sector, the tertiary sector doesn’t deal with raw materials or material goods. Retailers, financial companies, trading companies, entertainment companies, and tourism companies are the players in this segment. The tertiary sector is usually very labor-intensive.
  • Quaternary Sector: The quaternary sector deals with high intellectual demands, including consulting (tax, business, medical, educational), IT services, high technology (biotechnology, nanotechnology, …), communication technology, and other demands.

Please take note that not all agree on how industries fit into the tertiary or quaternary sector. So some people might have a different perception.

I think it’s essential to be aware of the dependencies between the sectors and how disruptions in one sector can lead to disorders in other sectors. Questions I usually want to have answered for sectors are:

How are the sectors performing?

  • How are the sectors performing overall and among each other?
  • Are the average revenue and profit increasing or decreasing?

This can give a sentiment over which sectors are performing well, and which don’t perform well. There might be some sectors which don’t perform well, which will perform well in the future. Some sectors might continue to perform well. Other sectors will not perform well, and it is better to avoid them.

Where are the sectors in their current business cycle?

  • How will the sector do in the current economic environment?
  • Is the sector cyclical? If yes, at which point in the cycle is it?

If you look at mining companies, you might want to know, if there is currently a shortage in supply which drives up demand, or if there is oversupply. This will determine if sales and prices are high or low.

What are potential threats to the sectors?

  • Are there any natural disasters that might hurt the sector?
  • Is there a pandemic or other hazard?

It might not be wise to invest in an insurance business, after a Tsunami, or entertainment or tourism businesses during a pandemic.

Influx & Outflux of investments

  • Which sectors will most likely profit from investments?
  • Which sectors will enjoy less investment?

If there are sectors, that have technological advantages, the sectors might be favored by investors, while other sectors might be stagnant.

From where can you get the data?

You can find sector relevant data on Tradingeconomics.

What are the Broker risks?

You will need to utilize a Broker to buy or sell financial assets. You want to make sure, that you conduct your business with a trustworthy Broker that is regulated by the respective monetary authority of your country. You should avoid unregulated Brokers.

Most people I know that lost money with stocks did so because they’ve trusted their money to an unregulated fund, money manager, or broker.

How well capitalized is the broker?

Even though there are not that many cases in which brokers go bankrupt, it can happen. It makes sense to check how well the broker is capitalized by looking at the balance sheet.

How long has to broker been in business?

It is advisable to chose a broker that some track record.

How is the broker regulated?

Which monetary authorities regulate the broker?

What access does the broker have to your capital?

  • Does the broker have direct access to your account?
  • Is the broker allowed to withdraw your money, or can the broker only trade with your money?

There are setups that prevent brokers from directly accessing your money. Brokers are only allowed to invest your money, but not withdraw your funds. You do good to check how you are protected against brokers, having direct access to your capital.

What happens if the broker goes bankrupt?

Check if your financial assets are held separate from the companies assets, and how you are protected against the broker’s bankruptcy.

What are the fees?

  • What’s the cost to purchase the financial assets?
  • What’s the cost to sell the financial assets?
  • What’s the cost for withdrawing money?
  • Is there an account holding minimum?
  • What’s the cost for cancelling the account?

You need to ensure that you know the costs, especially for withdrawing funds and for cancelling your account. Some Brokers will charge you heavily if you decide to withdraw money or close your account. This is where you can see how sincere your broker is.

How can the broker be reached?

If you have any problems, for example technical problems, such as trades not closing, or others you want to be able to get in touch with your broker to help you. Check how you can reach support, and how long it takes for the support to respond.

Did other people encounter problems?

Search the internet for the name of the broker including the words “issue” or “fraud”, or any other such terms, and look through the complaints. You will always find negative voices, and it’s not always the broker’s fault. But you’ll notice quickly that if many people repeat the same issues, that it might be better to stay away.

What are the risks of buying shares?

If you buy shares of a company, you buy a part of the company, with all its risks and rewards.

How well is the company capitalized?

  • How long can the company survive with its reserves?
  • How much debt does the company have?
  • If the company is international how are its subsidiaries doing?

Companies that have a solid cash cushion and low debt will usually be able to weather an economic downturn, while companies that have no reserves and high debt might go bankrupt quickly.

Is revenue and profit growing?

  • Is revenue and profit growing or shrinking year on year?
  • From where is the revenue originating? Is it from products? Or other sources?

Companies with a steady increase in revenue and profits will most likely continue to do so if they have good products. It is important to know from which source the revenues and profit are generated. The company might make money in other ways, such as selling its own company assets in times of crisis, or it might be making money through other investments and insufficiently through their products.

Generally, the company should have stable growth through product sales. But there are years, where unforeseen things happen, and this can be a good thing, as you can buy in cheap, if you determined, that the company has only had a temporary setback.

What are the cashflows?

The cash flow statement shows, how much money flows into a company, and how much money flows out. This will give you a good indication of how the company is doing. It’s like managing your own cash flow. If more money flows out, then there is money flowing in, the company will have a problem at some point.

How high are the operational costs?

The operational costs are all the costs the company has, to create, market, and distribute their products. It might be worth comparing the operational costs against the companies competitors to see how efficient the company is being run.

What are the companies products?

  • What kind of products does the company sell?
  • How much revenue and profit does each product generate?
  • Who are the buyers, and why do they buy?
  • What keeps the customers from purchasing from the companies competitors?
  • How big is the moat the company has with its products against its competitors?

By analyzing the products and the companies moat against competitors you can determine how well the company will do in the future. If the company has patents on their products if it is the brand that makes the company successful, or if it’s not possible for other companies to copy the products in any other ways, then the company will most likely continue to do well.

How is the management like?

  • How long are the people that run the company in business?
  • How much skin do they have in the game?
  • Is there a high level of fluctuation in top positions?
  • What do the managers stand for?
  • What’s the companies strategy for the next years?

Most of times a stable management with years of experience and a solid plan will achieve better results, than a company that is in turmoil and has constant fluctuations.

More

Investors can dig very deep into the company, to understand each and every aspect, before investing into it. Even though I think I have covered the most important points, there is a lot more that can be discovered.

From a risk perspective, you want to know the dark and blind spots, that others might not see. But if you don’t find any significant ones, then it might be a good investment.

What are the risks of buying bonds?

If you buy a bond you lend a company or the government money over a certain period of time. For this, you will receive interest payments.

What are the terms of the contract of the bond?

Bond contracts can be very difficult, so you should read the contract carefully before you sign it and hand over your money.

When are the interest payments paid out and what’s the maturity date?

When will the interest payments be paid, and when will you be paid back the initial sum?

Is the bond secured or unsecured?

You can purchase secured or also unsecured bonds.

When a bond is secured, it means that if the company defaults, it can repay you partially or in full.

When a bond is unsecured, it means that if the company defaults, they will not be able to repay you, but you might receive some money back, once all the assets of the company have been sold. This will usually be distributed among its creditors.

What’s the bonds credit rating?

There are institutions like Moody’s, Standard & Poor’s, and Fitch, which will provide credit ratings on bonds. Bonds that are above BBB or BAA (depending on the credit agency), are considered to be investment-grade bonds.

Bonds with a lower rating are also called junk bonds and are riskier, but usually have higher interest payments.

How is the company that issues the bond doing?

Which company has issued the bond, and how is this company doing? You can refer to the analysis of shares above, to analyze the company.

What is the return of the bond?

How much does the bond return, in relation to the inflation rate? Will the bond beat inflation?

What are the risks of buying Mutual Funds?

What are the goals of the fund?

A fund will always have a prospectus with defined goals that the fund manager will need to adhere to. Read the funds prospectus and all it’s supporting documents.

What happens if the fund issuer goes bankrupt?

In many cases, the fund’s assets and the companies assets will be held separate, which means that if the fund issuer goes bankrupt, your assets will still be there. This is however something that you’ll have to clarify upfront.

What access does the fund issuer have on your account?

  • Does the fund issuer have direct access to your account?
  • Is the fund issuer allowed to withdraw your money, or can the fund issuer only trade with your money?

There are setups that prevent fund issuers from directly accessing your money. Fund issuers are only allowed to invest your money, but not withdraw your funds. You do good to check how you are protected against fund issuers, having direct access to your capital.

How is the fund issuer regulated?

Which monetary authorities regulate the fund issuer?

Are there any custodians involved, and how are they liable?

If you read the prospectus of Gold funds you might discover, that there is usually a custodian, a Bank for example that manages the Gold reserves, and buys or sells gold, based on the fund’s value. The custodians are in many cases not obliged to guarantee that the full fund is backed by Gold. This means that if anything happens, and not the full value of the fund is guaranteed to be backed with real gold, it could lead to problems.

You might be better off investing in gold with your local bank directly, depending on the purpose. If it’s a hedge, and only a small percentage is in gold, then a mutual fund or ETF will be fine, but if you want to hold long term and be sure you can access the physical gold, then it might be better, using a local bank.

Is the fund sufficiently diversified?

Check how diversified you are with your fund, based on your requirements. If you are investing in the S&P 500 you will be well diversified as you own 500 of the largest companies in the US, but you might still also want to be diversified from a currency perspective and country perspective. You could for example invest into two mutual funds, a US fund in USD and a Chinese fund in Renminbi.

Into which assets does the fund invest?

Into which assets is the fund invested to which percentage? There might be a higher percentage in one sector than in other sectors.

Is the fund leveraged?

Do you lend money when you purchase the fund? And if you do, what are the interest payments and how much can you lose?

How is the fund performing?

How has the fund been performing over the last couple of years? Has there been a steady growth? And why do you think will the fund be doing well in the future?

Who is managing the fund and how is it managed?

Who is the fund manager and what is his track record?

What are the risks of buying ETFs?

The difference between Mutual Funds and Exchange Traded Funds (ETF) is, that:

Mutual Funds are usually actively managed (a fund manager picks and manages the assets in the fund), and purchases or withdrawals can only be made at end of the day.

Exchange-traded funds are passively managed, and in many cases mirror an index, such as the S&P 500 index. Exchange-traded funds are similar to mutual funds from a contract perspective, but can be traded at every time during the day, during the stock exchange opening hours.

So ETFs share the same risks as mutual funds. One risk that an ETF might have, which a mutual fund doesn’t have is that people can exit the Fund, whenever they want, which might lead to higher fluctuations in the price.


How to track risks

In order to track the risks, I utilize the same approach, as with projects. An excel sheet with the following columns:

  • Risk/Threat (the threat when purchasing the asset)
  • Events (Events that can trigger the threat)
  • Probability (The probability of the event occurring)
  • Impact/Severity (how much money could you lose?)
  • Mitigations (how you can mitigate the risk?)
  • Monitor (does the risk need regular monitoring?)

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

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