How do you manage market risk in investments?
Investing in stocks and other securities means accepting a certain amount of exposure to market risk. In simple terms, market risk means that there is a possibility that your investments will lose money. There are various factors that can affect how stock prices move and what that means for your portfolio. Understanding how market risk is measured can help you develop a strategy for managing its impact on your investments.
To help develop your own strategies for managing market risk, consider working with a financial advisor.
What is the market risk?
Market risk is the risk of investments losing their value due to changes in the overall market temperature. This type of risk is also referred to as systemic risk since it is built into the market system as a whole and is not specific to any one industry or sector.
There is no way to eliminate market risk, as it can be driven by a number of factors outside the investor’s control. In other words, you cannot diversify your path through asset allocation alone. There are several subcategories of market risk that can affect investors in different ways.
interest rate risk. Fluctuation in interest rates can increase volatility in the markets and directly affect the prices of securities. Bond investors may be particularly affected, as bond prices and interest rates have an inverse relationship.
currency risk. Currency risk is the risk of losing value when exchanging one currency for another. If you hold investments in a foreign currency and the value of that currency drops, your investment will be less valuable.
Commodity risk. Commodities are the raw materials from which other products are derived. When commodities experience price volatility, this can have a ripple effect throughout the broader market.
Equity risk. Stocks or stocks have inherent risk because their prices are not fixed. There are many factors that can cause price movements in stock markets, including geopolitical events, the introduction of new government regulations or a public health crisis.
What is the best measure of market risk?
Value at risk or VAR is the most widely used statistical method for measuring market risk. The VAR method is used to calculate the probability of two things:
VAR technology can be useful for measuring market risk for a variety of investments, including stocks and bonds. There are various methods for calculating VAR, starting with the historical method. In this case, you can simply take the historical returns of an investment or a stock market index and rank them from lowest to highest. By looking at the highs and lows and where they are concentrated, you can make an informed guess about where you expect losses to maximize.
The second method of calculating VAR uses expected returns and standard deviation to determine the best and worst periods of a stock’s performance. Similar to Method 1, you can use this to make a projection of how you expect the stock to perform in the future.
You can also use something called Monte Carlo simulation to calculate VAR in order to measure market risk. This strategy uses hypothetical scenarios to predict stock price movements and future returns. Running multiple simulations can give you a loss range to work with to estimate potential losses.
While VAR is often used to measure market risk, it has some drawbacks. While it may be easy to apply one of these calculation methods to a single stock, things can get more complicated when you look at a larger group of assets. It is also worth noting that the three calculation methods may not produce identical results, which can make it more difficult to measure market risk.
What is the market risk premium?
The market risk premium is the difference between the expected rate of return for a stock index or stock market index and the risk-free rate of return. The risk-free rate means the expected return on the investment in the absence of risk. You can use the market risk premium to estimate market risk.
When you calculate the market risk premium, you are trying to figure out what will happen to the stock price if volatility increases. The market risk premium can tell you whether the expected return on an investment is justified by the increased risk involved.
How do you manage market risk in investments?
While diversification can be an effective way to manage other types of risk, it is not nearly as effective in dealing with market risk. However, there are some things you can do to mitigate the different subcategories of market risk.
For example, if you have bonds in your portfolio, it is important to pay attention to what is happening with interest rates. Interest rate cuts can cause bond prices to rise, while higher interest rates can push them down. If you are in a rising price environment, short-term bonds may be the best option to manage the risks associated with changing bond prices.
If you invest in foreign markets, you can manage currency risk by being careful when allocating assets and studying the currency profiles of those markets. Holding a mix of investments backed by strong currencies can be another strategy to hedge market risk.
Looking at the general state of the market can help you adjust your asset allocation when volatility increases. For example, if you believe the economy is about to slide into a recession, you might choose to move money out of the consumer discretionary sector and invest more in defensive stocks. For example, utilities and basic consumer goods can provide reliable returns in the early stages of a recession, as people still need to spend money on these things day in and day out.
Dollar cost averaging is not necessarily a risk management tool, but it may help mitigate returns through changing market cycles. The dollar-cost averaging strategy simply means that you keep investing the same amount of money on a regular schedule, and outperform market volatility over time. This is different from the average value, which makes you invest more or less money depending on the performance of your portfolio at any given time.
One last way to manage market risk is to simply avoid risk altogether. Instead of investing in stocks, bonds, or other securities, you may choose to keep your money in certificates of deposit (CDS), money market accounts, or savings accounts. While these options can provide security, with almost no risk of losing money, the returns may be much lower than you would realize in the market.
Market risk is unavoidable if you hold stocks, bonds, mutual funds or other securities in your portfolio. Various factors shape the face of the markets daily, which can bode well – or badly – for investors. The good news is that while you cannot completely bypass market risk, you can take steps to manage its impact on your investments.
Consider talking to your financial advisor about the best ways to manage market risk when creating wealth. Finding a qualified financial advisor doesn’t have to be difficult. The free SmartAsset tool matches up to three financial advisors who serve your area, and you can interview your own advisors at no cost to determine which one is right for you. If you’re ready to find a counselor who can help you achieve your financial goals, get started now.
Taking an online risk assessment questionnaire can help you establish a baseline for your personal risk tolerance. But it is important to remember that these questionnaires may be limited, in terms of the scope of the questions asked. Your tolerance for risk may be at one level but your risk capacity, or the amount of risk you need to take to achieve your goals, may be at another. Failing to close the gap could cause you to fall short of your goals, which is another good reason to consult a financial advisor when developing a risk management strategy.
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The topic “How to Measure and Manage Market Risk” was first published on the SmartAsset blog.