May 29, 2022|Education- 2 min
What is Risk Mitigation?
Risk mitigation is about reducing risk. Every investment has risk, and the risk appetite of investors varies with their situation in life.
Risk cannot be eliminated, but it can be managed by reducing the uncertainty surrounding a potential investment.
Types of Financial Risks
Financial risk falls into two categories: systematic and unsystematic risk. Systematic risk affects the performance of an entire market due to geo-political and macroeconomic factors. Unsystematic risk affects a specific industry or company. Some risks affect all investors.
Interest Rate Risk
Valuations are determined by the present value of future earnings based on the time value of money. Higher interest rates increase the time value of money and reduce the value of future earnings. Valuations drop when interest rates rise, and rise when interest rates drop.
Changes in investor sentiment affect valuations. Valuations rise when investor sentiment is positive, and drop when they are negative.
Depending on your base currency, the value of your investments in foreign countries is subject to the value of the foreign currency relative to your base currency. If you invest in Japan, for example, an appreciation in the Japanese yen against your base currency would improve your returns, while a depreciation would reduce it.
The value of your investment is only theoretical if you cannot sell it on demand. Private equity, for example, cannot be converted to cash on demand. Similarly, thinly traded public investments cannot be sold on demand. In both cases, a distressed sale would be subject to a deep discount.
The circumstances of borrowers may change. They may be unable to service their debt and default on their obligations.
Some investments may benefit from Inflation, such as properties where rents are repriced with inflation. But the value of fixed rate debt will drop in an inflationary environment because it cannot be repriced.
Investment Horizon Risk
Your investment horizon may be shortened unexpectedly, forcing you to liquidate your investment at an inopportune time.
Understanding uncertainties may not eliminate risk, but it may reduce the chances of a negative outcome. Check our Risk Profiler tool.
Risk Mitigation Strategies
Investment professionals cannot avoid losses. But they can adopt strategies that mitigate financial risk to reach long-term financial goals.
Asset allocation and diversification are the most effective strategies to minimize financial risk. Allocating an investment portfolio to different asset categories by sector, industry, and region minimize financial risks.
Building a successful investment portfolio that achieves your goals starts with identifying your risk tolerance. A trusted financial advisor will monitor your investments regularly and rebalance your investments to survive market fluctuations.
Risk Mitigation Best Practice
Investors should seek the highest returns with the lowest risk. Schedule a call with our advisors to learn more about risk mitigation strategies at The Family Office.