Risk is a fundamental concept in investing. No discussion of the profitability of various strategies and financial instruments makes sense without an analysis of their riskiness. However, determining the level of risk and all the factors that influence it is not an easy task, especially for new investors.
Risk and volatility
Quite often, volatility is a risk factor. This is a measure showing how strongly a certain figure can change over time. The wider the window of possible changes, the higher the likelihood that any of these changes will be negative. Volatility is relatively easy to measure – this is a plus. But this is not an ideal tool for determining the level of risk.
In practice, the fact that a more volatile stock or other financial instrument exposes the owner to a larger number of possible outcomes does not mean that something bad will happen. In many cases, volatility can be compared with turbulence during air travel – a bit unpleasant, but has nothing to do with a real catastrophe.
Risk is better perceived as the likelihood or possibility that the asset will permanently lose its price or it will not rise to the level that the investor needs. For example, if he plans to earn 15% on a deal, then the probability that the benefit will be lower is the risk of an investment.
At the same time, the insufficient productivity of the trading strategy is relatively more general indicator such as index growth. For example, if the S&P 500 index grew by 10%, a specific stock grew by 8%, and the investor expected to make a profit of 7% – this will not be a situation where the risk was realized.
What is a high-risk investment?
Portal investopedia so describes high-risk and low-risk investments. In general, investments are considered high-risk if, when they are made, there is a high probability of a significant or complete loss of money or loss of profit at the level of expectations. Again, much depends on reproduction.
For example, if you describe some kind of investment as having a chance to bring the expected profit of 50 to 50, it would seem risky to someone. If the likelihood that the investment does not bring the desired profit is at the level of 95%, this will be too risky for almost everyone.
This means that it is necessary to evaluate not only the probability of a negative outcome, but also the scale of possible losses.
Low risk investments
In turn, low-risk investments not only mean protection against losses, it also means that even if a negative scenario is realized, the consequences will not be terrifying.
For example, biotechnology company stocks are considered highly risky. Approximately 85-90% of all experiments with new drugs fail, and as a result, many shares of biotech companies in the end also lose much in price.
That is, there is a great chance of both losing profit and a complete loss of money (usually, if a biotechnology company has bad business, stocks lose 95% or more in price).
Conversely, buying federal loan bonds with using an IIS account – This is a low risk investment. Firstly, benefits on such an account (tax deduction of 13% or exemption from income tax on investments) can increase the overall profitability. A high level of reliability is achieved due to the fact that federal loan bonds are a state debt. If it refuses to pay it, it will mean default with corresponding consequences for the entire financial system of the country. The chance for this is extremely small.
What else do you need to know
In determining the level of risk, there are other parameters that should be considered. For example, diversification affects the riskiness of an investment portfolio. For example, the shares of large companies that pay dividends are usually quite reliable – with them you can get predictable earnings, which, however, will not be very large.
But one company can always go bankrupt, and many companies at once are unlikely. Therefore, you should not keep all shares in one basket, because if all investor funds are concentrated in one asset, the probability of a negative outcome increases. If there are ten assets in the portfolio, the risk is significantly reduced.
In addition, it is important to analyze the risk level of each asset. If the portfolio has different instruments, but all with the same level of risk, this can be dangerous. That is, the chance of a plane crash as a whole is always small, but many large airlines had plane crashes. If you have only government bonds in your portfolio, the risks are low, but if they are realized, the consequences will be catastrophic.
The risk is also affected by the investor’s planning horizon. If he wants to make a profit very quickly, usually the risk will be higher than with a long-term investment.
In any case, it is necessary to analyze not only the probability of a negative outcome, but also the extent of possible losses.
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