The importance of risk management has never been greater than today. With the acceleration of globalization, the threats facing contemporary businesses have become more complex. While new threats emerge regularly, investment risks are broadly divided into the following three categories: market risks, business risks and corporate governance risks.
The risk of losing money on your investments due to market risks is inevitable. Market risks affect all investments, regardless of their size. Even if the companies you have invested in are doing well, your investments may be priced lower by the market. Or, if you decide at any time to liquidate some or all of your holdings, buyers may not be available. The golden rule to remember is to protect your capital. Although such risks cannot be completely predicted or avoided, a portfolio can be protected by being vigilant, prudent and aware of market changes to limit risk exposure.
One tactic to protect yourself from market risk is to allocate capital appropriately. Diversification is beneficial in various ways and therefore investing in multiple asset classes reduces unsystematic risk (investing in a single company) since the loss is limited.
The assets you decide to add to your portfolio are also important here. When you combine a number of uncorrelated assets, you will achieve a more balanced return, as you will always have an alternative to fall back on if any of your chosen investments are affected by market fluctuations. This reduces the volatility of your portfolio. However, it is equally important to avoid the other extreme of too much variety in your investments.
Owning and operating a business always comes with its own set of risks. Therefore, your investment is subject to the risk of underperformance of the business. For example, when you buy a stock, you are buying part of the ownership of the company. Alternatively, when you buy a bond, you are lending money to a company. However, these investments require the business to stay in business in order to generate returns.
Ordinary investors are the last to receive the proceeds if a company goes bankrupt and its assets are liquidated. Typically, in such cases, bondholders receive payment first, followed by preferred shareholders. If you own common stock, you will receive whatever remains, if any. If you are buying an annuity, be sure to assess the financial strength of the organization offering it. You want to be sure that the business is financially stable and likely to continue to operate successfully over the long term. To identify these risks, an in-depth study of a company’s specific activity is necessary. Again, capital diversification should be used in the same way as market risk is managed.
Corporate governance risks
Corporate governance is important because it sets out a system of rules and policies that govern how a business operates and how the interests of all its stakeholders are aligned. Such oversight enables ethical business practices which, in turn, lead to financial viability.
As an investor, you want to make sure that the company you are considering investing in has strong corporate governance to protect you from any loss.
If you invest in a company with weak corporate governance standards, you risk exposing yourself to the impact of potentially fraudulent activities, such as book dressing and embezzlement of corporate funds. Great care should also be taken when examining the workings of a company’s management. The first step to verifying this is to read the company’s auditor’s report, which can be found in the financial statements filed on the stock exchange.
Always keep in mind that we don’t manage risks to avoid them completely, but to understand which ones will help us achieve our investment goals and pay off enough to justify taking those risks. Ultimately, all investments carry some level of risk. However, by better understanding the nature of risk and using measures to limit exposure, you put yourself in a better position to achieve your financial goals.
In addition to keeping the above points in mind, it is also essential to maintain adequate liquidity, consult a financial advisor before investing, and hedge a company-wide view using a strategy. effective enterprise risk management. Making an investment doesn’t mean your job is done; on the contrary, it has just begun. Indeed, understanding the market, keeping an eye on the fluctuations and trends that could affect your portfolio, evaluating your investments and reworking your asset allocation if necessary are all essential to reduce the risks of your portfolio.
Hersh Shah is CEO, Institute of Risk Management, India Affiliate, and Mohit Mehra is Head of IPO, Zerodha
(Disclaimer: The views expressed are those of the author and Outlook Money does not necessarily endorse them. Outlook Money will not be liable for any damages caused to any person/organization directly or indirectly.)