Modules for Traders
Introducing the statistics of risk
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Avoiding vs. reducing risk
Throughout this entire module, we’ve discussed a great deal about the statistics of risk. But did you know that there are four different ways to manage risk? Yes, the four primary ways are:
- Risk avoidance
- Risk reduction
- Risk transfer
- Risk retention
And in this chapter, we’re going to be looking at two of them - avoidance and reduction. At first glance, they may appear to overlap significantly. But when you take a closer look, avoiding risk is very different from reducing risk. We’ll take them up one after the other and see what the differences between these two are.
Risk avoidance is all about eliminating any exposure to risk that could pose a potential loss. One of the strategies that traders and investors use to manage risk is to avoid investing in any asset with risks altogether. Well, think about it. You can’t actually face losses when you don’t invest in anything risky in the first place, right?
Here’s an example that can help you comprehend the concept of risk avoidance.
Let’s say that you’re an avid motorcycle rider. As you’ve previously seen in the first chapter of this module, motorcycle riders are at a significantly higher risk of getting into accidents. Now, how do you manage this risk? Going by the concept of risk avoidance, you can only do this by completely avoiding motorcycles altogether. When you don’t ride a motorcycle at all, you completely eliminate the chances of you crashing your vehicle, right?
This is exactly what traders and investors do as well. They avoid risk by not investing in investment options that possess high amounts of risk. This protects their investment capital from going into losses and keeps it intact.
Is risk avoidance a good idea?
Now, it might seem to you that avoiding risk is a great way to manage it. However, it comes with its own pitfalls. Here’s a quick look at why risk avoidance may not be such a great idea.
1. You forego the benefits that come with risk
Firstly, by avoiding risk you also eliminate the chances of getting any benefits that you might have otherwise experienced had you taken that risk head-on.
Let’s take the previous example of motorcycles into consideration once again. By completely avoiding motorcycles, you might think that you’ve eliminated the risk of getting into an accident, but you’ve also foregone the ability to get to your destination quickly. You would have to take other alternative forms of transportation, or you might even have to walk the entire distance. This can significantly increase the time taken to get to your intended destination. Can you see how you’ve given up the benefit of quick transportation in a bid to avoid risk?
Again, this is what would happen to traders and investors who avoid risk as well. By not investing their capital in high-risk (and consequently high-reward) instruments like stocks or derivatives, they’re essentially foregoing the possibility of earning high returns.
2. You cannot fully avoid risk
Another reason trying to avoid risk is not a very prudent idea to begin with has to do with the fact that risk, as such, can’t be fully avoided. As much as it sounds absurd and unrealistic, it is in fact true in the context of the financial markets. No matter how much you try, you can’t fully get rid of risk altogether.
Here’s a very good example.
Let’s turn our heads toward the motorcycle example once again. Now, when you refrain from using motorcycles and adopt alternative modes of transportation, you might think that you’ve avoided the risk of getting into an accident. But in fact, you’re still under the same risk. How, you ask? When you swap your motorcycle for a car, there’s a chance of you getting into a car accident. And when you swap it for walking, even then, there’s still a chance of you getting into an accident due to the actions of a third party.
Even if you decide to not go anywhere and sit at home, you’re again under the risk of getting into an accident; you could fall down and get injured, for instance. You now get the gist, right? No matter what you do, you can’t fully avoid risk whatsoever.
This same concept applies to traders and investors as well. If an investor chooses to not do anything with their investment capital and simply holds it in cash, they’re basically swapping investment risk for inflation risk. Though the level of investment risk is higher and more serious than inflation risk, the fact that you cannot fully escape risk remains.
Risk reduction entails the adoption of different methods to reduce the overall risk of an investment option or an investment portfolio. Reducing risk is a strategy that many traders and investors use to manage risk.
Here’s the motorcycle example once again to help you understand the concept.
As you know by now, motorcycles are easily one of the best modes of transportation to reach destinations quickly and without much hassle. You like the thought of it, but are you also concerned about the risk of getting into an accident? In that case, what do you do? Instead of trying to avoid the risk altogether, you can try to reduce it to the maximum possible extent.
How, you ask? By riding in a sedate and cautious manner, by wearing a helmet, and by equipping your motorcycle with adequate crash protection and an anti-lock braking system. With all of these systems in place, you can significantly reduce the risk of getting into an accident.
Similar risk reduction methods can also be adopted by traders and investors to reduce their investment risk. Here’s a quick look at some of the most popular methods used to reduce risk.
- Asset diversification: Portfolio diversification is one of the most popular methods used by investors to reduce risk. By possessing a good mix of assets from different classes, you can effectively bring the overall investment risk down.
- Hedging: Hedging strategies are most commonly used on high-risk investments such as futures and options to reduce their overall risk. For instance, if you take a long position in the futures on a particular stock and wish to reduce the investment risk, you could hedge the position by initiating a short position on the same stock.
- Adequate due diligence: Traders generally use several analytical techniques, both fundamental and technical, to ensure that they initiate the right position on a stock at the right time. By carrying out these kinds of due diligence techniques, you can reduce the investment risk considerably.
Here’s why risk reduction may be a better idea than risk avoidance
The single most important reason why risk reduction may just be a better idea for managing risk has to do with the fact that it gives you a chance to create wealth.
By completely staying away from investing in a bid to avoid risk, you’re essentially robbing yourself of an opportunity to generate returns. That’s not all. By holding cash, you are also exposed to inflation risk, which ends up reducing the value of your money gradually over time. And so, by trying to avoid risk, you’re not only reducing your investment value, but also foregoing the ability to increase your capital.
With risk reduction, on the other hand, you still get to invest in the option of your choice - the only condition being the use of risk mitigation tactics like the ones discussed above. This can end up increasing the chances of you getting your intended returns without much of a downside risk, thereby allowing you to realize your financial goals.
With this, we’ve come to the end of another module. However, we’re not fully done with risk as of yet. In the next module, we’ll be discussing more about risk and risk management techniques. Keep reading and keep learning, with Smart Money.
A quick recap
- Risk avoidance is all about eliminating any exposure to risk that could pose a potential loss.
- One of the strategies that traders and investors use to manage risk is to avoid investing in any asset with risks altogether.
- By avoiding risk you also eliminate the chances of getting any benefits that you might have otherwise experienced had you taken that risk head-on.
- Another reason trying to avoid risk is not a very prudent idea to begin with has to do with the fact that risk, as such, can’t be fully avoided.
- If an investor chooses to not do anything with their investment capital and simply holds it in cash, they’re basically swapping investment risk for inflation risk.
- Risk reduction entails the adoption of different methods to reduce the overall risk of an investment option or an investment portfolio.
- Reducing risk is a strategy that many traders and investors use to manage risk.
- Asset diversification, hedging and due diligence can help reduce risk.