Risk management is part of everyday life. For example, people are constantly managing risks on a regular basis when it comes to driving a car, etc. It is worth mentioning that, when it comes to financial markets and business administration, assessing risks is a crucial as well as very conscious practice.
In the case of traders and investors, the framework may include the management of multiple asset classes, such as cryptocurrencies, Forex, commodities, etc. People should be aware of risk factors. Importantly, there are many types of financial risks, which can be classified in various ways.
It is worth noting that the risk management process involves five steps: setting objectives, identifying risks, risk assessment, defining responses, as well as monitoring. However, depending on the context, these steps may change significantly.
Let’s start with the first step. People should define the main goals. Interestingly, it is often related to the risk tolerance of the company or individual. Importantly, how much risk they are willing to take to move toward their goals.
Interestingly, the second step involves detecting and defining what the potential risks are. It wants to reveal all sorts of events that may cause negative effects. People should take into account that, in the business environment, this step may also provide insightful information that is not directly related to financial risks.
Risk management and important steps
Let’s have a look at the third step. Importantly, after identifying the risks, the next step is to evaluate their expected frequency as well as severity. Moreover, the risks are then ranked in order of importance. This way, it is easier to create or to adapt according to the appropriate response.
Furthermore, the next step consists of defining responses for each type of risk, based on their level of importance. Notably, it establishes what is the action to be taken in case of an unfavourable event.
The fifth and final step is a risk management strategy. The purpose of this step is to monitor its efficiency in response to events. Interestingly, this often requires a continuous collection as well as analysis of data.
People should take into account that, when it comes to financial risks, there are several reasons why a strategy or a trade setup may be unsuccessful. For instance, a trader can lose money because the market moves against their future contract position or because they get emotional and end up selling out of panic.
Unfortunately, emotional reactions often cause traders to ignore or give up their initial strategy. Interestingly, this is particularly noticeable during bear markets and periods of capitulation.
It is worth noting that, when it comes to financial markets, most people agree that having a proper risk management strategy contributes drastically to their success. For instance, in practice, this could be as simple as setting Stop-loss or Take-Profit orders.
Importantly, a strong trading strategy should provide a clear set of possible actions, meaning that traders can be more prepared to deal with all sorts of situations. As stated earlier, there are numerous ways of managing risks. The best solution is to revise the strategies on a regular basis to adapt to the ever-changing environment.
How to cope with financial risks
Let’s have a look at several examples of financial risks and how to cope with them. For example, it is possible to minimize the market risk by testing Stop-Loss orders on each trade so that positions are automatically closed before incurring bigger losses.
Moreover, it is possible to reduce the liquidity risk by trading on high-volume markets. In most cases, assets with a high market capitalization value tend to be more liquid. Interestingly, when it comes to credit risk, it makes sense to trade by using a trustworthy exchange so that borrowers and lenders (or buyers and sellers) don’t need to trust each other.
It is worth noting that investors can mitigate operational risks by diversifying their portfolio, preventing exposure to a single project or company. It also makes sense to find companies that are less likely to experience operational malfunctions.
Moreover, it is possible to reduce the systematic risk by diversifying the portfolio. However, in this case, the diversification should involve projects with distinct proposals or companies from different industries. Last but not least, traders should pay more attention to risk management.