If, during the Battle of Britain, a Londoner elected to put off his evening stroll until conditions were safer, you wouldn’t accuse him of being a scaredy cat. But if your friend refused to ever leave his house on the grounds that a pot plant might fall on his head, you might raise an eyebrow.
It’s similar in the case of financial risk: Some kinds should give you cause to hesitate before handing your money over, while others – less so. Nobody would say the ideal is to experience no risk at all. In fact, an economy may actually require a certain amount of risk to be taken, in order to keep flourishing. And the same goes for your personal wealth. The question of risk management turns around assessing different kinds of risks in terms of their likelihoods and potential impacts.
Risk applies differently to different people, too. When SEC Chair Gary Gensler laid charges against certain celebrities for promoting crypto products last year, he reminded the public that the risk faced by these people in putting their money into digital assets is dramatically lowered by their high wealth levels. A tolerable risk for a millionaire may be intolerable for you and me.
What are the main types of risk, and how are they handled?
Systematic risks are risks that affect an entire market or industry, or a large part of one. An example of this is interest rate risk: When the US Federal Reserve raises interest rates, the likely impacts will extend across wide areas of the economy. Another example is political risk: When hostilities are building between two nations, as they were between Russia and Ukraine in March 2022, there are a range of industries in both involved countries, and beyond them, that could feel the effects if things get out of hand, (as we indeed saw in the months that followed). The same would apply to inflation risk, which, as we experienced last year, tends to exert a widespread influence over the economy. This type of risk is difficult to mitigate. All people can do are things like tweaking the time horizon on their trading instruments and hedging as much as possible against assets bound up in the known risk.
A good illustration of systematic risk is foreign exchange risk. In the event an American company buys a product manufactured in Japan, payment may be stipulated in Japanese yen. Then, if the yen appreciates in value relative to the USD between contract signing and date of delivery, the US firm may have to pay an extra sum of dollars for that same delivery. This is called transaction risk. Or, when a US company takes in large portions of its income in its Japanese stores, it will have to translate all those earnings back into dollars, which could equally be affected by changes in the exchange rate. Translation risk like this is often addressed with the use of advanced financial products like forward contracts or options.
And then there are the types of risks associated with a particular industry or sector or product. These are unsystematic because they are driven by specific and unique factors that won’t necessarily influence a wide segment of the economy. In February this year, Bitcoin’s New Year rally ran into a brick wall when US regulatory bodies cracked down on the crypto sector. Bitcoin lost 6% within only three days, and the largest 100 digital coins dropped by a median of 5%. Prices were plummeting because “the community fears that the regulatory pendulum will swing the other way aggressively”, explained Cici Lu of Venn Link Partners. By contrast, a basket of liquid staking tokens – similar to cryptocurrencies but less vulnerable to regulatory pressure – surged by 9% in a single day.
Wherever there was risk of a clampdown, securities dropped, and there wasn’t a clampdown everywhere. This is why it’s a simpler job to manage this kind of risk – using good old diversification. If your financial trading involves securities in different industries, each with its own correlation to specific risk factors, your personal risk is reduced. Similarly, you could diversify across different kinds of assets, like bonds, ETFs, and stocks. Or, you might want to spread your capital over assets bound up in various geographical regions. This way, a political or climatic crisis in a particular spot on the globe couldn’t knock down all of your assets in one go.
The presence of risk in financial trading is something to adjust to, not avoid. If it weren’t for risk, there wouldn’t be so much incentive for us to gauge the true value of an asset, or direct our funds into worthwhile enterprises, as opposed to useless or detrimental projects. What’s needed for your financial trading is a methodical way of facing and assessing risk, which you should read about in the specific contexts of your financial instruments.