Understanding risk is essential for any individual to make good returns on their investments. This is why Risk Analysis is an integral part of investing. Smart investors always assess the probability of negative events occurring when proceeding with projects, due to corporate, technical, political or environmental causes.
Risk can come from anywhere and in the form of anything. Whether it is a disruption in the cash flow, a project shutting down or the devaluation of a business, these events can cause major losses for investors. This is why uncertain events should be analysed well and the probability of a project succeeding or failing should be identified.
Not just this, future market conditions, unfavourable legalities, potential cash flow streams and stock return or portfolio variances should also be evaluated. Decisions should be based on the data acquired from analysts, forecasting or guaranteed returns. There should be a perfect balance between welcoming risk and reducing it. Without high risk, generally, rewards are not that great. This is why, in this modern market, at one point, every investor must incur a certain level of risk.
Table of Contents:
- Risk Analysis and Risk Profiling
- Risk and Returns
- Ensuring the Right Risk-Reward Ratio with Good Investments
Risk Analysis and Risk Profiling
Risk analysis is one of the most crucial aspects of investing. This field allows investors and even corporations to assess the probabilities of adverse occurrences or abnormalities. Anomalies can sometimes cause a huge influx of cash, however, they might also stop the cash flow stream altogether. Analysing the risk involved with investing in a project or business also allows investors to determine if it is worth investing or spending their hard-earned money.
Not just that, expert risk assessment allows investors to even reduce the risk or remove triggers for anomalies. Risk management is focused extensively on what can potentially go wrong and how. These events that can have a negative impact on the investment are weighed against probability metrics to determine the chances of these events actually occurring. Next, risk management ensures that the impact of the event and the extent of the losses are identified. For example, it can be market risks, geopolitical risks or credit risks. One can also neutralise or mitigate these risks by employing a good insurance policy.
Risk profiling is also a huge part of risk analysis, allowing one to evaluate if the risk and reward ratio is worth it. A potential investment opportunity must fulfil certain criteria, such as adding future value, beating inflation or predicting gains. Without a strategy to help manage this risk, one cannot calibrate their full portfolio. Maintaining consistency is key and investing in various opportunities as opposed to depending on a single cash cow is the way to go. Like we discussed earlier, risk is of different types. It can even be in the form of realised losses or regulatory trouble.
Risk profiling takes a comprehensive approach to analysing the financial and behavioural factors of a business or project. There are many risk assessment tools as well that can be used for developing your portfolio and maintaining a healthy risk-reward ratio.
There are two types of Risk analysis:
- Quantitative Risk Analysis: In this analysis, risk models are developed using deterministic statistics or through simulations for assigning cognizable values to the risk. Then, assumptions, estimates and other variables are provided as inputs into this model. Example – A Monte Carlo Simulation can be used for generating a range or set of probable outcomes that are a result of any action or decision. In this simulation, the results are different once various inputs are fed, thus, allowing one to understand the variance of risk.
- Qualitative Risk Analysis: With this analytical method, one does not assign numerical values to risk. This is not a quantitative method and involves defining uncertainties, anomalies and the impact of the risk. The total extent of the impact is also identified and countermeasures are developed and analysed to see how effective they are as well. Example – SWOT analysis, Game Theory, Decision Matrix, etc.
Risk and Returns
The risk-reward concept is a ratio that enables investors to determine how comfortable they are with the risk they are willing to incur for the potential returns or rewards. Whenever one invests money, there is always a small or large risk that the money will be lost or go to waste. In order to peacefully bear that risk, a reward that is desirable must be expected. Even if there are potential losses, a good portfolio can fetch a great combined return. The vice-versa is also true as a good portfolio can also reduce the combined risk. Before getting into investments, one must determine their risk preferences. This fundamentally translates to how much risk is worth taking for the investor. There is no ‘one size fits all’, in investments and one must personalise their very own risk model when investing. Risk tolerance is different for everyone and different factors are applicable during certain scenarios or financial environments. Risk and returns are correlated, thus, if one is expecting increased rewards, one must incur increased risk as well.
However, there are two general preferences that investors go for:
- Time Horizon: This approach focuses more on the total amount of time investors can afford to invest their money for.
- Bankroll: This approach revolves around how much money investors can afford to lose.
Ensuring the Right Risk-Reward Ratio with Good Investments
There are many factors that can influence the risk or rewards that an investor is involved with. However, diversifying your investments can reduce the combined risk. Even though massive potential returns might get limited, this is a great way to reduce risk while still earning rewards. Investing in different industries or sectors is also important as any sector might significantly outperform others. If one invests in a single sector, in case the sector suddenly plummets, this would completely destroy one’s investments. The base way to go about this is following a pyramid structure for investing. Let us understand what this pyramid comprises.
First, there is the base. This is the foundation of your investments and comprises low-risk investments that might not have huge returns but are guaranteed. One must use the largest percentage of their funds for investing in this base.
Then, there is the middle area. These consist of medium-risk investments that are relatively safe but have stable returns.
And finally, the tip or the summit. This area should only consist of high-risk investments you are confident about and only a selected few. This is the smallest chunk of your investments and should only be funds that you are fine with losing.
Here are some other ways investors can ensure good investments by minimising risk:
- Adopt new concepts which promote productivity and place more preference over future periods rather than the current scenario
- Increasing forecasting accuracy and removing errors in estimates
- Revision of cutoff rates to protect against uncertain returns
- Not depending on the individual possibility of sales, value or costs
- Obtaining a combination of high, medium and low estimates that are a perfect mix of positive and negative expectations
- Market analysis, investment cost analysis
- Identifying fixed costs and operating costs
Risk analysis is essential for identifying, measuring and reducing risk and exposure to negative events. Thus, it is crucial for investors to understand risk management and risk profiling. Also, your investments should align with your interests.