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What are the main sources of financial risk and how can you mitigate them?

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Financial risk is the possibility of losing money or facing negative consequences due to factors that affect the performance of your investments, business, or personal finances. It can arise from various sources, such as market fluctuations, interest rate changes, inflation, credit defaults, liquidity issues, or operational failures. Managing financial risk is essential for achieving your financial goals and protecting your assets. In this article, we will explore the main sources of financial risk and how you can mitigate them with some practical strategies.

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1 Market risk

Market risk is the risk of losing money due to changes in the prices or values of your investments, such as stocks, bonds, commodities, or currencies. Market risk can be affected by macroeconomic factors, such as economic growth, inflation, interest rates, political events, or natural disasters, as well as by specific factors, such as company performance, industry trends, or consumer demand. To mitigate market risk, you can diversify your portfolio across different asset classes, sectors, regions, and styles, as well as use hedging techniques, such as options, futures, or swaps, to reduce your exposure to adverse price movements.

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Brandon King, MBA, PMP

Director, Operations at Sanofi | MBA | PMP
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Market risk is an inherent part of investing, but there are ways to manage it and still benefit from potential market returns. Diversification is one of the most effective strategies to manage market risk. By investing in a variety of asset classes, sectors, regions, and styles, we can spread our risk and minimize the impact of any single market event. Real estate can play a crucial role in a diversified investment portfolio by offering low correlation to other asset classes like stocks and bonds. To build a diversified portfolio, it's essential to invest in a diverse mix of asset classes, use different investment vehicles, rebalance regularly, consider the risk-return tradeoff, and stay disciplined while avoiding emotional decisions.

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Jay Mota, CFP?, CDFA?, WMCP?, ChFC?, CQS?, MAFF?

Financial truth seeker through analysis, strategic financial planner, and investment advisor. Public Speaker and Educator.
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Human behavior is the biggest risk to portfolios in my opinion. Poor decisions driven by emotions lead investors to make bad decisions. As a wealth manager, I always tell my clients we cannot control what happens in the market, but we can control what decision we make and when. The other financial risk also involves behavior. This is not having an individual investment strategy for each financial goal. If you properly allocate your savings based on the goals time horizon, then market swings should be mitigated with time. The investment risk (tolerance) should match the time horizon goal. Managing behaviors do not eliminate all the risks in the article, however investor behavior helps to not suffer unnecessary losses.

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Ayan Halder
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Market risk is real. Stocks returns paid far more than any other investments over the last decade. With the market finally rationalizing itself, some of the things I considered: - reduce exposure to high growth stocks by moving to low volatile and dividend stocks. This might be a great time to explore setting up dividend based cash flows. - Explore real estate investing. It need not be huge money into one property. Several businesses allow shared ownership of rental and short-term lease properties. Travel is picking up so it is a good thing to consider. - Bonds and T-Bills are nearing 5% annual returns. Low but guaranteed returns over a 3 year term can potentially beat the inflation.

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Charlotte F.

Global President at The New Global Web | The World's First Digital Economy by Country" Veteran Financial Planner /Wealth Manager at Afsafin Private Clients/ Founder - Wowman Construction (Pty) Ltd
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Key Components of Market Risk Equity Risk:Definition: Risk of loss due to changes in stock prices. Impact: Can significantly affect investment portfolios, particularly those heavily invested in equities. Interest Rate Risk: Definition: Risk of loss due to changes in interest rates. Impact: Affects bond prices, loan rates, and can influence broader economic conditions. Currency Risk:Definition: Risk of loss due to fluctuations in exchange rates. Impact: Particularly relevant for businesses involved in international trade and investment.Commodity Risk: Definition: Risk of loss due to changes in commodity prices.Impact: Affects industries dependent on raw materials, such as manufacturing and agriculture.

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2 Interest rate risk

Interest rate risk is the risk of losing money due to changes in the level or direction of interest rates, which affect the value and cash flow of your fixed-income investments, such as bonds, loans, or deposits. Interest rate risk can be influenced by monetary policy, inflation expectations, supply and demand of credit, or market sentiment. To mitigate interest rate risk, you can adjust the duration and maturity of your fixed-income portfolio, as well as diversify across different types of bonds, such as government, corporate, or municipal bonds, with different credit ratings, coupons, and features.

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Charlotte F.

Global President at The New Global Web | The World's First Digital Economy by Country" Veteran Financial Planner /Wealth Manager at Afsafin Private Clients/ Founder - Wowman Construction (Pty) Ltd
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Mitigation Strategies: Duration Management: Strategy: Adjust the duration of an investment portfolio to align with interest rate expectations. Benefit: Reduces sensitivity to interest rate changes by balancing the portfolio's exposure. Interest Rate Swaps: Strategy: Use interest rate swaps to exchange fixed-rate payments for floating-rate payments, or vice versa.Benefit: Provides flexibility in managing interest rate exposure and can stabilize cash flows. Diversification: Strategy: Diversify investments across different maturities, sectors, and geographies. Benefit: Spreads risk and reduces the impact of adverse interest rate movements on any single investment.

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3 Inflation risk

Inflation risk is the risk of losing purchasing power due to the increase in the general level of prices of goods and services over time. Inflation risk can erode the real value and return of your investments, especially if they have low or fixed interest rates, such as bonds, savings accounts, or annuities. Inflation risk can be driven by demand-pull factors, such as strong economic growth, consumer spending, or fiscal stimulus, or by cost-push factors, such as rising input costs, wages, or taxes. To mitigate inflation risk, you can invest in assets that have the potential to increase in value or income faster than inflation, such as stocks, real estate, commodities, or inflation-linked bonds.

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Sara Faridi

I am a Viking Norse half American. SIEM Securities Entrepreneur. If my community can afford to make sure that I can afford it, then the economic system of Capitalism is the winner. You can build with us@ 1(714)395-1776
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Inflation, hyper-inflation and raising the rates can be replies to the market international trade policies. Its a good reason to review foreign news.

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4 Credit risk

Credit risk is the risk of losing money due to the failure or inability of a borrower or issuer to repay their debt obligations, such as principal, interest, or dividends. Credit risk can result from default, bankruptcy, insolvency, restructuring, or downgrade of the credit rating of the borrower or issuer, which can affect the value and liquidity of your investments, such as bonds, loans, or stocks. Credit risk can be influenced by the financial health, cash flow, leverage, and profitability of the borrower or issuer, as well as by the economic and market conditions. To mitigate credit risk, you can diversify your credit exposure across different borrowers, issuers, industries, and regions, as well as assess the credit quality, rating, and covenant of your investments, and use credit derivatives, such as credit default swaps, to hedge against credit events.

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5 Liquidity risk

Liquidity risk is the risk of not being able to buy or sell your investments quickly or easily at a fair price, due to low trading volume, high transaction costs, or market disruptions. Liquidity risk can affect the availability and cost of funding, as well as the performance and valuation of your investments, especially if you need to sell them urgently or unexpectedly. Liquidity risk can be caused by market-wide factors, such as financial crises, regulatory changes, or investor sentiment, or by asset-specific factors, such as complexity, maturity, or transparency of the investments. To mitigate liquidity risk, you can maintain a sufficient cash reserve, diversify your sources of funding, monitor your liquidity position and needs, and invest in liquid and marketable assets, such as money market instruments, exchange-traded funds, or blue-chip stocks.

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Stephen Hudd

Former Regional Managing Director at Wells Fargo
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Whether in households or the largest firms, a major risk overall is personal perspective impacting what should be analysis driven decision making. I can’t remember how many times I heard the goal of a fortress like balance sheet as a worthy and necessary goal only to be supplanted by C- suite level impulse and leader derived decisions that ultimately created a weakened position. Again, the C-suite can be at the household level or household -name firm level. The consequences are loss of flexibility and sometimes loss of control. The consequences of this type of influence, personality overriding analysis must be guarded against at all levels. We can all reflect on such examples in life and in business.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Daniel S.

Capital Markets Risk Management, and nonlinearity. Volcker rule, Complaints, Conduct, AI.
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I would add Model Risk. If your model do not account for specific circumstances as they seem too farfetched (e.g. when designing model in the 90's, negative interest rates in EUR and GBP were not plausible), you may face major issues.

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What are the main sources of financial risk and how can you mitigate them?

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1 Market risk

2 Interest rate risk

3 Inflation risk

4 Credit risk

5 Liquidity risk

6 Here’s what else to consider

Management

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What are the main sources of financial risk and how can you mitigate them?

1

2

3

4

5

6

1 Market risk

2 Interest rate risk

3 Inflation risk

4 Credit risk

5 Liquidity risk

6 Here’s what else to consider

Management

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