Identifying, understanding, and minimizing risk is essential to any well-planned financial portfolio. It is essential to be prepared for unexpected events to achieve peace of mind over your finances. History has always shown us that economic uncertainty is vastly unpredictable. Therefore, we need to know what to do to protect ourselves and our portfolio from different forms of uncertainty.
What are the major risks?
Investment risk is the possibility that an investment’s actual return will differ from its expected return. Risk-averse investors want to avoid this, while risk-seeking investors accept the opportunity in exchange for higher expected returns. Risks come from external forces (world events) and internal forces (like your own behaviour).
The two major types of external risk are systematic risk and unsystematic risk. When you invest in the market, you’re taking on both risks.
Systematic risk (also called market risk) is the level of uncertainty that affects all investments similarly, such as changes in interest rates, inflation, political unrest, or economic recession.
Unsystematic risk (also called specific or unique risk) is less broad than systematic risk and refers to risks specific to one company or industry.
But the most significant risks that we currently face are not external factors like interest rates or inflation but rather internal factors such as our own emotions and behaviours.
How can we measure risk?
There are five principal risk measures: alpha, beta, R-squared, standard deviation, and Sharpe ratio. Each measure has its advantages and disadvantages.
- Alpha: The alpha is the expected return of an investment relative to the overall market’s return.
- Beta: Beta is a measure of how much an investment’s price changes in response to changes in the price of its benchmark index.
- R-squared: R-squared measures how similar the returns on one investment are to those on another investment.
- Standard deviation: Standard deviation is a percentage that describes how much an investment’s returns vary from its mean return over time and provides a measurement regarding an investment’s volatility.
- Sharpe ratio: The Sharpe ratio measures risk-adjusted performance, comparing an investment’s expected return with its risk over a certain period.
When comparing two potential investments, it is wise to compare the like-for-like figures to determine which investment holds the most risk.
How do we insure against risk?
Investing is risky. There are no guarantees that you’ll get the returns you expect. But if you have a diversified portfolio, are guided to manage your emotions, and have a trusted financial advisor, you can reduce your risk and increase your chances of success.
Diversify your portfolio
Diversification is the practice of investing in a variety of assets, such as stocks, bonds, real estate, and commodities. Investing in more than one asset class reduces your risk and protects against volatility.
Manage your emotions
Behavioural economists have found that investors are often swayed by emotion rather than logic when making financial decisions. The defining feature of market crashes is the panic sell-off caused by fear, negative outlook, and human physiology. It’s common for investors to panic when they see their portfolios drop or jump with joy when they see them rise quickly. But these feelings aren’t based on any facts — they’re just reactions your brain has developed over time in response to market fluctuations. So remember that investing should be about focussing on long-term goals rather than short-term emotions.
Trust your advisor
Most people want to enjoy their retirement years without having to worry about money. You need to make sure you work with a trusted advisor to do that.
It’s natural to want control over your finances — especially when the market drops or when interest rates rise unexpectedly. But if you’re reacting to the market, chances are you’re making suboptimal choices that aren’t in line with your long-term goals. Avoid making decisions based on fear or greed; instead, stick with what works for you and let an experienced professional help guide you through any bumps in the road.
What about our stock market?
It’s worth noting that the stock market has historically recovered from most downturns. In addition, it’s important to remember that over the long term, companies continue to grow, innovate and develop new products and services that will help them thrive in the future. It means that while short-term volatility may occur, long-term investors should still be able to profit from their investments.
If you’re a long-term investor looking to profit from this volatile environment, it is an excellent time to review your portfolio and consider whether there are any opportunities for improvement and optimization.
How does this relate to macroeconomics?
Macroeconomic factors are often very complex and can significantly impact companies, industries, and markets. It is always good to know what is going on in the macroeconomic environment when you invest. There are two main types of macroeconomic events that can impact your investments:
1) International economic events (e.g., oil price changes)
2) Domestic economic events (e.g., interest rate changes)
These economic events may positively or negatively affect the value of your investments, depending on how they affect the economy and how market participants perceive them. On the international side for example, an increase in oil prices may increase inflationary pressures, which would be negative for equities.
And on the domestic side an event such as an increase in interest rates may mean higher return in the equity market.
The good news is that there’s a lot you can do to protect yourself from the effects of macroeconomic events on your investments. And if you’re willing to take on more risk, you can harness these same forces to boost your returns.
We can protect ourselves even in a world of uncertainty.
In a world of uncertainty, the best way to protect our portfolios is to take advantage of opportunities.
The financial markets have been on a roller coaster ride this year. While it’s tempting to think that these events we have seen represent new risks that have been introduced into our lives, they are not new at all. We’ve had a lot of experience with volatility in the past, and we can use that experience to our advantage.
I believe that now is a good time for investors to consider adding protection to their portfolios as uncertainty is always ahead. We can do this by understanding and managing our risks, saving more, investing wisely, and diversifying our investments.