What is Risk Management?

Many investors have difficulty figuring out exactly what risk means to them. But this is an crucial topic to understand if you are to succeed in today’s markets. In the financial world, risk management is the process of identifying and handling uncertainties in one’s investment decisions. If you can manage your risks, then your investment’s should perform well over time. As the most famous investor Benjamin Graham once said, “the essence of investment management is the management of risks, not the management of returns.”

How to Properly Analyze Investment Risk

Whether it is investing, playing sports, or driving down the street, you are constantly exposed to risk. Your demeanor and lifestyle choices largely determine how much risk you are comfortable with. When it comes to investment risk, your temperament play a major role in shaping your risk tolerance. Since risk is defined as the likelihood of a financial decision’s outcome being lower than the expected return of a particular investment. To this end we have to examine a few factors that will determine your tolerance for risk.

  • Asset Allocation. You have to balance risk versus reward by managing the percentage of each asset class in your portfolio according to your personal risk tolerance. The two primary types of investments are equities, which tend to have higher risk and returns, and fixed income, which has lower risk with matching lower returns for the most part. Proper asset allocation should create long term portfolio growth, while providing fixed income stability.
  • Time Horizon. The longer you have to invest before taking money out the more risk you can take on with investments that tend to have higher volatility and returns over time. For example, growth companies such as FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) and private equity may provide better long term returns as a whole. But in the near and medium time horizon they can be very volatile.
  • Personal financial situation. Your income level, savings rate, job stability, investment knowledge, household budget, debt level, and borrowing rate can all have an impact on your risk tolerance. Some investors are comfortable and prefer picking individual securities, while others may choose to use index funds or low cost robo-advisor services.
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