What is risk management?
We are constantly managing risks throughout our lives – either during simple tasks (such as driving a car) or when making new insurance or medical plans. In essence, risk management is all about assessing and reacting to risks.
Most of us manage them unconsciously during everyday activities. But, when it comes to financial markets and business administration, assessing risks is a crucial and very conscious practice.
In economics, we may describe risk management as the framework that defines how a company or investor handles financial risks, which are inherent to all kinds of businesses.
For traders and investors, the framework may include the management of multiple asset classes, such as cryptocurrencies, Forex, commodities, shares, indices, and real estate.
There are many types of financial risks, which can be classified in various ways. This article gives an overview of the risk management process. It also presents some strategies that can help traders and investors mitigate financial risks.
How does risk management work?
Typically, the risk management process involves five steps: setting objectives, identifying risks, risk assessment, defining responses, and monitoring. Depending on the context, however, these steps may change significantly.
Setting objectives
The first step is to define what are the main goals. It is often related to the risk tolerance of the company or individual. In other words, how much risk they are willing to take to move toward their goals.
Identifying risks
The second step involves detecting and defining the potential risks. It aims to reveal all sorts of events that may cause negative effects. In the business environment, this step may also provide insightful information that isn’t directly related to financial risks.
Risk assessment
After identifying the risks, the next step is to evaluate their expected frequency and severity. The risks are then ranked in order of importance, which facilitates the creation or adoption of an appropriate response.
Defining responses
The fourth step consists of defining responses for each type of risk according to their level of importance. It establishes the action to be taken in case an unfortunate event occurs.
Monitoring
The final step of a risk management strategy is to monitor its efficiency in response to events. This often requires a continuous collection and analysis of data.
Managing financial risks
There are several reasons why a strategy or a trade setup may be unsuccessful. For example, a trader can lose money because the market moves against their futures contract position or because they get emotional and end up selling out of panic.
Emotional reactions often cause traders to ignore or give up their initial strategy. This is particularly noticeable during bear markets and periods of capitulation.
In financial markets, most people agree that having a proper risk management strategy contributes drastically to their success. In practice, this could be as simple as setting Stop-Loss or Take-Profit orders.
A robust trading strategy should provide a clear set of possible actions, meaning that traders can be more prepared to deal with all sorts of situations. As mentioned, though, there are numerous ways of managing risks. Ideally, the strategies should be revised and adapted continuously.