Risk Management and Stock Market

In stock market there is strong relationship between risk and return. Greater the risk, greater the return generally! In financial terminology risk management is the process of identifying and assessing the risk and then developing strategies to manage and minimize the same while maximizing the returns.

Every investment demands a certain amount of risk and for an investor to assume this risk he has to be compensated duly. This compensation is in the form of something called as the risk premium or simply the premium. Risk is therefore central to stock markets or investing because without risk there can be no gains. Successful investors use stock market risk management strategies to minimize the risk and maximize the gain.

In financial markets there are generally two types of risk; first the Market Risk and second the Inflation Risk.

  1. Market risk results from a possibility in increase or decrease of financial markets.

  2. The other risk i.e. the Inflation or the purchasing power risk results from rise and fall of prices of goods and services over time.

The inflation risk is an important consideration in long term investments where as the market risk is more relevant in the short term. It is the market risk that can be managed and controlled to a certain extent, inflation risk cannot be controlled.

There are certain strategies that can be employed to mitigate the risk in a stock market. The strategies are as follows:

  1. Follow the trend of the market: This is one of the proven methods to minimize risks in a stock market. The problem is that, it is difficult to spot trends in the market and trends change very fast. A market trend may last a single day, a month or a year and again short term trends operate within long term trends.

  2. Portfolio Diversification: Another useful risk management strategy in the stock market is to diversify your risk by investing in a portfolio. In a portfolio you diversify your investment to several companies, sectors and asset classes. There is a probability that while the market value of a certain investment decreases that of the other may increase. Mutual Funds are yet another means to diversify the impact.

  3. Stop Loss: Stop loss or trailing tool is yet another device to check that you don’t lose money should the stock go far a fall. In this strategy the investor has the option of making an exit if a certain stock falls below a certain specified limit. Self-discipline is yet another option employed by some investors to sell when the stock falls below a certain level or when there is a steep fall.

Ask Warren Buffet, the greatest investor of all time, what is your advice to investors and he says ‘don’t lose money!’ But stock market connotes risk and fortunately there are enough strategies for a wise investor to safeguard his money and ensure gain. A careful and timely exercise of these options helps you see of the risk involved.

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Risk Management