Investment risks that can be hedged if you follow these steps

Here is a reality check - all investments have risk. There is no way to get around it. Nothing is safe from it - stocks, bonds, or alternative assets. Even the risk-free assets are not free from their own kind of risk i.e. inflation risk. They will not generate enough returns to keep up with the rising costs. Hedging is the key. Hedging is prevention. You may not be able to completely protect your investment from risks but you can hedge some preventable losses.

In this article, we discuss some of the more unknown steps:

1. What is investment risk?

Investment risk is the uncertainty of losing the value of your money due to market conditions. It can stem from any factors - business, economy, borrowers and etc. The risk of losing is the fear every investor has and hence, they take certain measures to hedge against them. As such, there are some things you need to understand before putting your money in any investments, such as:

  • The correlation between risk and reward - that is, the level of risk attached to the asset class or the investment with the returns on investment. This will clarify whether you should invest in that asset or whether the risks are worth the reward. For example, stocks carry a significant amount of risk but the returns are worth that risk. Hence, stocks are such a popular asset class
  • The volatility of the investment in average - check the historical volatility of the particular investment or the asset class to give you an idea of its fluctuation degree. You should determine whether you will able to tolerate the investment volatility without losing everything in the process
  • Understand and develop a risk management strategy to help you manage the risks that are appropriate for your portfolio. Not all strategies will ensure your investment returns. You must learn the investment strategies to identify, analyse and manage the risk. Understand individual strategies will help you hedge against market risks and allow you to modify them when necessary

2. Types of investment risks

Not all risks are the same and not all carry the same level of volatility. Different types of risks have their own hedging methods and it also depends on the types of investments, types of risk, market conditions, asset class, the level of volatility it carries, correlation factors, long-term/short-term, and many more. Below, we look at some of the basic types of investment risks.

Business risk

Business risk has to do with the health of the company, whether they can bring in profits. It will look at whether sales are enough to generate an income that can cover operational expenses and still leave a profit. Operational expenses can be salaries of employees, rent, cost of production, office, and administrative expenses. The risk also depends on the demand for their services, so that they are no losing money trying to keep their company afloat.

Credit risk

Credit risk is also known as a default risk where you have to assume that the borrower will fail to pay his loan and you will lose on the interest and/or the principal money you have invested. Certain credit risks have a low risk of default, like that of government bonds, but also have the least returns. Others credit lendings are riskier but generate a good return on interests. Fortunately, there are a number of ways where you can mitigate your credit risks.

Market risk

Market risk can be defined as the risk of losses arising from unfavourable movements in market prices. There are three major types of market risk:

  • Interest rate risk: Interest rate risk happens when the value of an investment changes because of the changes in the interest rates. This rate risk interest affects bonds more than stocks because the increase in interest rates worsens the value of the bonds. The interest rate risk also affects the secondary market where the bond prices increase and interest rates decrease. Interest rate risk can be prevented by fixed-income investments, which will be discussed in detail
  • Equity risk: Equity risk mostly applies to the stock market, as in, the fluctuation of stock price happens due to its demand and supply, and the risk is that there may be a drop in the value of the stocks
  • Foreign currency risk: You should only be worried about currency risk when you own foreign currencies as an investment. For example, you are holding US Dollars while living in the EU. The risk is that the value of those dollars may drop and will be worth less in Euros

Liquidity risk

Liquidity risk refers to whether your investment allows you to take out cash whenever necessary. Of course, most of the investments have liquidity risk because they are held in the investment for the long term. Hence, many hold extra liquid funds on the side to prevent this.

Inflation Risk

This is more relevant if you have some savings in a regular savings account. Inflation is the decline in purchasing power which will increase the cost of others and thereby, living. This means, food that you were buying for 2 euros, is now 4 euros, thanks to inflation. Not only savings are affected by inflation, some investments too - such as bonds. Hence, many proponents insist people to have investments on the side to offset the inflation of their savings.

The list above is not exhaustive and is some of the many types of investment risks out there. Other types of investment risks include concentration risk, reinvestment risk, horizon risk, and many more.

3. Hedging investment risks

You cannot completely remove investment risk. However, you can manage and prevent some of the investment risks. As such, asset allocation and diversification are absolutely necessary to hedge investment risk in general. Asset allocation will help you to spread your money and increase your chances to offset a volatile asset against a more stable asset and still generating sufficient interest. Diversification supplements allocation by minimising your investment risks.

As such, hedging depends on the type of investment. All asset classes have their own volatility and risks and hence, there are some specific hedging methods to prevent losing money and generate higher returns. As such, credit risks can be hedged through a number of steps:

  • By charging your borrowers a higher interest who are more likely to fail
  • By purchasing credit insurance to transfer risk to the insurer
  • Through collateral from the borrowers, which can be held until the payment is made or seized if the borrower defaults
  • Diversifying between borrowers, lending to multiple borrowers in small amounts to dilute risk

For inflation risk, most investors suggest not put all the money in a savings account but diversifying in several investments, such as in mutual funds, stock market, real estate, and others for a period of time. However, it does not mean you should keep nothing in a savings account for it will hedge against liquidity risk should you need the cash. The same should be applied to business risk through keeping extra capital to keep the business operating, should the sales not generate enough profits.

Interest rate risk, under market risk, can be hedged through various fixed income investment products, such as forward contracts, interest rate swaps, options, and many more. Investors need to research the varieties of fixed income instruments to understand their characteristics.

Foreign currency risk, also, under market risk, can be hedged with currency swap forward contracts to manage it. It means the investor can lock in the price they will pay for the foreign currency. A lot of ETFs and funds manage their currency risk, in the same manner, to keep it from inflating too much.

Equity risk, like everything else, can be hedged with similar tactics already discussed.

Risk is unavoidable. However, it does not have to be a daunting experience to prevent it. Hedging against investment risks can be challenging and yet a valuable learning experience for investors. Whether or not you will need all the hedging strategies, understanding their characteristics will give you an upper hand in your investment portfolio. 

Last update: 06/08/2021

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