Profitability and risk are two concepts that are related. When we want to obtain high returns, we have to take equally high risks. That is why it is important to know how to measure the risk of investments, to know if the ratio between risk and potential profit is worth it.
In this article we will talk precisely about this, the risk of investments, to know the types of risk that exist, and learn the most effective methods to manage it.
Let’s go there!
What is the risk of investing in the stock market?
The financial risk is the probability that an investment does not allow us to obtain the expected profitability, factors related to market liquidity of the company, or other market-related and environmental reasons.
This risk can mean the total or partial loss of the investment. Depending on the level of leverage and the financial product that we use, the investment risk can increase significantly.
Market risk
Market risk is the probability that the investment will go into losses due to the market volatility itself, which is exposed to the results of the companies, to macroeconomic news, and to a myriad of variables that affect the price of shares.
Some of the main variables that affect the price of shares in the market are the following:
- Macroeconomic news
- Business results
- Industry trend
- Political risks
These factors significantly affect the shares listed on the market, increasing the volatility of their prices, and therefore, may affect the risk of our operations on the stock market.
Measure the risk of an investment
Once those variables that affect the risk of our investment have been detected, it is important to quantify and measure the risk, to determine which are the variables that are most affecting the risk of the investment.
Investment risk levels
The risk levels of an investment can be classified into 3 levels that go from less to more risk. The risk levels are determined by the expected profit potential, the risk increasing as the profitability of trading on the stock market increases.
Those products with less risk are located at the bottom of the pyramid, while those with greater risk are located at the top, as we can see in the image of the pyramid.
Risk level 1
In the first level of risk, we find financial products such as savings accounts or government bonds, which are fixed-income investments with an expected return of 1-2% per year and have a low level of risk due to their low volatility.
Risk level 2
In the second level of risk, we find stocks, mutual funds, or investments in real estate, which can provide us with a return of 4 to 10% per year on average.
The risk in the case of real estate assets is usually high, due to the high levels of debt used to carry out this type of operation, where it is common to request loans or mortgages to finance the investment.
In the case of investment in stocks and mutual funds, the risk will depend on the asset we buy and the volatility experienced by the market. As a general rule, volatility in equities is minimized in the long term.
Risk level 3
In the third level of risk, we find CFDs and other products that allow us to leverage. The profitability of this type of financial product is conditioned by adequate management of the investment risk.
The risk of this type of product is so high that in most cases the risk of the investment does not compensate for the potential profitability of the same.
Ways to manage risk
We cannot start investing without first having a system in which we mark our tolerance for risk. Next, we are going to see the most effective ways to manage risk:
Risk tolerance
We must all establish a certain tolerance for risk, based on variables such as the profitability we want to obtain or the psychological factor that affects our emotions when we observe that we are losing money on the stock market.
Each investor has their own tolerance for risk, and different reasons often come into play for each person. That is why we must know ourselves to be able to choose the strategy that allows us to obtain good returns, while we sleep peacefully at night without worrying about our money.
Diversify investments
Diversifying, also known as “not putting all your eggs in one basket,” is a tool to minimize investment risk. It consists of not concentrating our investment in a few companies, but we will invest in several companies from different sectors, profiles and geographical areas.
Thanks to diversification, if we make a bad investment in one of the companies, the effects will not significantly affect the total investment, since each company will have a small weight in the total portfolio of stocks.
In this way, if one of these companies turns out to be a bad investment, the impact it will have on our portfolio will be small, since it will be offset by the rest of the shares.
Reduce the impact of losses
If you put all of your capital in the stock of a single company, you risk losing most of your money, or all of it, if that company goes bankrupt. On the other hand, if you buy shares in different companies, the losses you suffer from the bankruptcy of one of them will not have such a devastating effect on your total investment.
That is why it is not only important to diversify, but it is essential to buy companies with low levels of debt and good businesses, which can generate an increasing flow of capital over the years.
Risk – Benefit Ratio
The risk-benefit ratio allows us to compare the expected return on the investment based on the risk we are going to assume.
In order to correctly calculate the risk/benefit ratio, we must compare the money that we will risk with the potential benefit that the investment can generate.
Example risk benefit ratio
If in our investment strategy we consider a risk-benefit ratio of 1: 2, it means that for every euro we invest, we expect a return of x2 times our capital.
For example, if we invest €1,000 in shares and we want to obtain a ratio of 1: 2, we will look for companies with a potential of 200%, with the aim that these €1,000 become €3,000 when our investment reaches our target price.
In this way, we will be able to risk a maximum of €1,000 of the initial investment, expecting a potential return of €2,000, which gives us that 1: 2 ratio.
This ratio is not only useful for long-term investment and trading, but it can also be used in other types of investments such as trading or real estate investment.
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