Investments inherently come with financial risks due to the unpredictable nature of financial markets. In addition, there are various factors that can influence the performance of an investment.
Factors that make investments risky
- Volatility: financial markets are volatile due to economic conditions, investor sentiment, and geopolitical events. In addition, volatility can increase or decrease at any moment, adding to the uncertainty of financial trading.
- Economic factors: economic announcements such as interest rate decisions, inflation, employment, trade balance and GDP growth rate influence the value of local certain assets. In addition, political events such as elections and changes in policies can cause asset prices to fluctuate.
- Risks associated with given assets: investing in individual securities exposes investors to company-specific risks, such as poor management decisions, operational problems, and competitive pressures that impact the stock value.
- Liquidity risks: low liquidity increases distance between the bid and the ask prices. As a result, traders and investors get high spreads for trading or investing in assets. Low liquidity also increases volatility due to the fact that there are less orders to find the best deal. In low liquidity environments price can make massive jumps.
- Lack of information: lack of quality education and information can also increase the risks. Information plays an important role in investing and is often considered one of the most valuable assets for investors. Market information helps traders identify opportunities in the market and make informed trading decisions.
- Human emotions: many people start investing to make a lot of money fast, which is risky. In investing, higher the risks, higher the potential for rewards. Greed can trigger traders to overtrade, open oversized positions and take huge risks. In addition, lack of discipline to follow trading rules, fear of opening a position, laziness and boredom can also damage investor’s pockets. Traders that are speculating with asset prices can feel bored when the right trading opportunities are not available and this can lead to opening orders that are not worth the risks.
- Changing market conditions: financial markets are evolving rapidly. Traders need to keep upgrading their skills to cope with the changing environment. Just a few decades ago financial trading was conducted from exchange floors. Development of high speed internet and modern computers has made it possible for retail traders to participate in the financial trading from their bedrooms. Many floor traders failed to remain profitable in the new environment. Nowadays, traders are faced with increasing competition from trading algorithms and artificial intelligence (AI). While computers are not as good as humans at analyzing economic and political events and seeing the whole picture, new technologies keep developing and nobody knows how the market will change in the future. Pattern recognition algorithms and trading robots are actively replacing human traders. According to J.P. Morgan, most financial trading is done by trading robots today. While trading algorithms and financial institutions have certain edge over retail traders, retail traders have some advantages as well. Retail traders are not pressured by their investors to make money, and this enables them to wait for the best trading setups and only trade when such opportunities present themselves.
Risk management strategies
- Diversification: diversification investment portfolio helps investors spread out their risks across different asset classes such as stocks, bonds, futures, real estate, and commodities. For beginner traders that are actively speculating with CFD (Contract for Difference) prices, diversification might not be a good idea. Beginners still have a lot to learn and it’s best to stick to a small number of assets.
- Use of stop loss orders: stop loss orders help traders to calculate risk reward ratio in financial trading. In addition, they limit potential losses by triggering automatic sell orders when the price of an asset reaches a specific level. By setting predetermined exit levels, traders protect their capital if the market moves against their predictions.
- Hedging: hedging is a commonly used method of limiting risks in finance. Hedging involves taking an offsetting position in a financial asset to reduce or eliminate the potential impact of adverse price movements. Investors often hedge against certain economic events. For example, let’s say you are swing trading EUR/USD and an upcoming economic announcement can damage your trade. You can open the same trade size in the opposite direction just before the announcement. And once the announcement is made and the threat is gone, you can close the hedging order. This process is costly, however, hedging works like insurance and protects traders from short term uncertainty. It should be mentioned that in some countries such as the USA, financial brokers are unable to offer clients direct hedging options due to regulations. However, it is possible to use one more hedging option and use highly correlated assets instead. For instance, it is no secret that the Euro and British Pound are highly correlated. Both areas are located close to one another and have strong economic ties. In addition, some currency prices are positively correlated with certain commodities, such as New Zealand, Canada, and Australia.
Overall, we can conclude that investing and speculating asset prices on financial markets comes with risks due to factors such as, volatility, economic and political factors, liquidity, lack of information, human emotions, and changing market conditions. Traders and investors are using hedging strategies, stop loss orders, and diversification to reduce their risks.