Investment risk: How to assess and reduce it?
Investments 101
September 11, 2024
Your capital is everything, and in fact, it's what matters most at the end of the day because without capital, you can't invest. That's why today at Hapi, we will share the types of risks you need to know, the best methods to calculate it, and some key tips to minimize it. Are you ready to face this risk together? Keep reading!
Every investment always involves a certain degree of risk; generally, as the risks of an investment increase, investors tend to seek higher returns to compensate for these possible risky situations.
One fact is clear: risk is part of our lives and is present in every decision we make.
Another situation we must be aware of is that inflation will always exist in any country, and no matter how small it is, over the long term, it can result in a loss of the purchasing power of our money. That's why investing is the best way to make our money work and generate returns above inflation (in fact, inflation is a specific type of risk that we will discuss in this post).
Risk is something that will be present in all the decisions we make. Many factors are beyond our control and can increase or decrease the level of risk, such as market volatility. Let's focus on what we can control—at least in part—and learn how to manage risk. In the end, the decision of how much risk you're willing to take is up to you.
Learn how each type of risk affects your investment! Let's take a look at them.
Let's start with the definition of the word "risk" from its etymology: It comes from the Arabic "rizq," which alludes to "what providence provides";
From Italian, with the contribution of "rischio" "risco," which refers to the rocks where ships were in danger; From Latin "resecare," which consolidates its relation to the meaning of danger, cutting, and dividing.
In the field of economics, the DRAE defines risk in an investment as the uncertainty that every investor has regarding the fluctuation of their assets' prices, caused by changes in the stock market.
With these insights, we can define it as follows: Risk is the probability that the outcome of your investment will not be what you expected. This also involves a possibility of losing part or all of your investment.
After having a clearer and more concise definition, we can move on to understanding the most common types of financial risks in the stock market.
Let's be brief and practical: 7 types of risks you should consider if you want to invest in the stock market.
But first, remember that every investment carries risk no matter how minimal it is. The greater the risk, the higher the potential returns on your investment.
This type of risk is quite common, also known as non-diversifiable risk, meaning that even if we have diverse assets in our portfolio (hence the name), it is a type of risk that, due to its nature, will eventually impact us.
We are talking about a direct impact on the market regardless of which specific company you have invested in, such as the one we are still experiencing, which began at the end of 2019, the Covid19 pandemic, which impacted the whole world, especially in the tourism sector, where until June last year, it had lost nearly 3 billion in the stock market due to the advance of the Delta variant. However, like market volatility, everything that goes down also tends to rise, which is why it's important to stay constantly informed to reduce systemic market risk.
The difference with non-systemic risk is that the latter encompasses those factors that we can control or at least partially control, thus allowing us to reduce some potential impacts, but we will discuss that later.
Also known as interest rate risk, it belongs to this systemic category because these are criteria outside the company's control, caused by changes and alterations in the overall stock market.
Although it can impact all types of assets, fixed-income investments, such as bonds or preferred stocks, are the ones that suffer the most.
This stock market volatility can cause prices to drop but also rise, allowing you to buy a stock at a good time and obtain significant returns.
We already talked about those external risks or factors that a company cannot control. In contrast, now we look at those internal criteria: Diversifiable risks.
These are a series of risks caused by the management of a specific company, from debt management, speculation, the type of business, defective products, overproduction, etc.
Some examples of non-systemic risk include poor performance results, sales data below expectations, new competitor products, fraud, and poor internal management, among others.
At some point in our lives, we've all heard about "inflation," and although many may not be able to define it precisely, they will certainly tell you that it negatively impacts daily life.
It is, therefore, an external factor that depends on a country's economy, so it could easily belong to a type of systemic risk, but due to its significant impact on an investment, we dedicate a section to it.
Inflation is a general increase in prices; this phenomenon reduces purchasing power, which is why it poses a risk for investors receiving a fixed interest rate.
Inflation will always be present in any country's economy, which is why we must consider it if we want to invest. When inflation occurs, it becomes difficult to distribute our income, plan a trip, pay off debts, or invest in something profitable, as prices, which were once a reference for allocating a certain amount of money, become distorted.
Investing your money is the best alternative to reduce the risk of money devaluation due to inflation. If you have investments in bonds or stocks, most prices will adjust according to the annual inflation index.
Investing in real estate also offers some protection against this type of risk because property owners can increase rents and property values over time.
In conclusion, we recommend investing your money and not keeping it at home because that money is being devalued by inflation; for example, let's say you wanted to buy USD 1000 in November last year (2021).
Initially, you needed 3,790 Colombian Pesos (COP) to buy those thousand dollars, and if you only kept them at home in local currency, due to inflation, you now need to spend 3,920 Colombian Pesos (COP) to buy the same USD 1000. In other words, you need to add 130 additional pesos; in less than 3 months, your initial money is no longer worth USD 1000. That's why we insist that you must make that money work and stay up to date with financial news; inflation affects everyone, and it's your responsibility to understand it.
Any changes in a country's regulations and/or regulations that alter the actions of the companies (in which you have invested) can affect you. It's also true that some regulations can benefit your stock portfolio, such as subsidies and tariffs on the industry that can result in a competitive advantage in the sector, so analyze this risk before buying a stock.
Some examples you should analyze include: government laws that restrict a corporation or industry, political instability, local environmental and product safety laws, tax regulations, local labor laws, trade policies, and monetary regulations.
Tip: To reduce legislative risk, consider investing in countries with established laws and avoid those with a pending regulatory framework.
Liquidity is the ease with which an asset can be converted into cash, so liquidity risk is a situation where an investor or a company has to sell their assets below market value.
In this regard, this type of risk is perceived when investors cannot find a market for their securities, at least not quickly, which prevents them from buying or selling when they want to. Our advice is to constantly review the stocks in your portfolio and follow stock market experts.
Now that you know the types of risk, the next question is, how do we assess a company's level of risk?
We already know what it is, how many types exist, so now let's take action:
How do we measure risk in an investment?
With a set of volatility, profitability, or return indicators. But data alone doesn't provide a definitive answer; it's necessary to make them work within a method, one suitable for what you need. Let's look at the two methods to evaluate it:
It focuses on evaluating the asset's volatility in the market, with its metrics showing the degree to which an asset's historical returns deviate from its average return rates.
Profitability indicators allow us to see the likelihood of returns varying by considering past data that must be well-framed within specific periods.
To forecast future probabilities, it's essential to have all the data from the company, including the costs its assets have incurred, to determine the variance from the average. In conclusion, the traditional method is about studying the past to predict future movements.
This method focuses on evaluating the value of the business itself, meaning that price behavior is not a significant risk indicator for this method. It presents a more optimistic and patient approach, as low prices represent a good time to invest, as long as the supply and demand elements remain positive in that market.
The real estate market could be an excellent example of the fundamental method, as despite external circumstances, it has managed to maintain itself and surpass inflation rates.
Applying the fundamental method requires having a solid base of information about the company and/or industry. Make sure to gather data such as their financial statements, the company's production capacity, the status of their debts, the popularity and sales of their products, relevant earnings announcements, the latest news affecting the company, and the financial performance of their competitors.
Where can you find this information?
If a company is listed on the stock exchange, it is required to share its financial statements periodically. This way, investors can access quarterly reports by simply visiting the company's website.
By now, you probably already know your financial profile. Our recommendation is that if you have a more risk-taking profile, always remember to research and analyze the company you are going to invest in.
Following the recommendations of veteran traders, looking for various podcasts to invest better, listening to specialists who share news about the financial and political environment on their YouTube channels, and informing yourself with reliable sources are always ways to reduce the fear of risk and ensure informed decisions in our investments.
Here are some tips to reduce some risks when investing in the stock market:
Are you in a LATAM country? Make sure to have a secure platform to invest in the US stock market with no minimums, easy registration, and proper backing ;)
Inform yourself before investing, research what is being said about that company;
Analyze possible trends in value changes;
Evaluate the current situation of the country where the company is located;
Diversify your investments to ensure returns;
Dare to use tools for risk management.
Minimizing the negative aspects of a high-risk investment depends on knowledge, and we are constantly learning. Make this your new goal for 2022, to learn how to manage your finances.
If you live in a LATAM country, what are you waiting for to discover Hapi? It's the perfect way to start investing, an app for buying and selling stocks in the US stock market, with no minimums and no commissions, focused on Latin American clients.
Follow us on our social media and stay updated on the latest stock market news, the best stocks to invest in, and continue expanding your financial vocabulary. Make the most of your time to keep learning!
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