Business Insights

In perspective

Three types of investment risks and how they can be minimized

November 19, 2017

When investments are made, any factor that can impair the successful exit to an agreement is considered risk. 

This includes any condition that can adversely affect costs, credit, length of terms, quality, or the level of certainty of a transaction.

To reduce possible effects, it is necessary to understand and analyze risk factors in a preventive manner, so any pertinent actions can be determined beforehand.

Risks that are linked to the entire economy, such as the possibility of a recession, are called systematic risks.

There are also non-systematic risks, which vary depending on the company that is being analyzed.

But, regardless of this partition, there are three main types of risks:

  • Liquidity risk is the possibility of a loss when an asset cannot be easily converted to cash when the debtor does not comply with agreements or there are excessive costs of compliance. This can affect large companies as well as family enterprises.
  • Credit risk depends on the entity offering the debt (such as banks or bond issuers) which at some time could eventually stop paying in accordance to the contract.
  • Market risk exists when there are losses in financial assets derived from adverse fluctuations in factors that drive price (risk factors), such as interest rates or exchange rates.

What is risk management?

The process of identifying potential events that could cause harm to a firm or its shareholders is called risk management.

Each type of risk requires a distinct strategy. One type of risk could be managed through different financial instruments or with a combination of various instruments.

The aim of risk management is to maintain risks at a low level in order to reach a reasonable level of certainty that the established objectives will be reached.

Management Phases

The risk management process involves various stages.

  • Identification. This establishes what can happen, why and how.
  • Analysis. Determines possible outcomes and the probability of each.
  • Evaluation. Compares the estimated level of risks versus accepted and predetermined levels.
  • Treatment. Develops and implements a plan of action, according to priorities that have been previously assigned to such risks.
  • Monitoring. Obtains required feedback to achieve continuous improvement in the risk management process.

In reality, the biggest risk is the unknown risk because being unaware of its existence will prevent any required measures to mitigate it.

In the case of risk factors, having the correct insight is not only powerful, but offers a level security, as it is used to counter such risks with financial instruments that provide the investor certain control measures.