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Investment risks: what are they and how to deal with them?
The difference between risk management in traditional and crypto markets.
Cryptos are known to be a risky asset class. So how do they differ from traditional markets and how should they be managed?
The concept of investment risk
Risks are omnipresent and part of our daily lives. It goes without saying that investing is an activity that can involve risks and it is important for any investor to understand this in order to make informed decisions.
Investment risks can be classified into two main categories:
- Macroeconomic risks, also known as systemic risks. They are related to the economy as a whole and can affect the entire market. These risks include factors such as interest rate fluctuations, exchange rate changes, inflation, business cycles and financial crises.
- Microeconomic risks, on the other hand, are specific to a particular company or industry. These risks can include factors such as the quality of corporate management, competition, regulations, unforeseen events, operational risks, credit risks, market risks and liquidity risks. Micro-risks are specific to each company or industry and may vary significantly from one company to another.
The relationship between risk and reward?
For any financial investment, there is a strong correlation between the level of risk associated with a decision and the potential reward that may result. In other words, the more risk involved in a choice, the greater the potential reward can be. This applies to many situations in life, from finance to personal life.
In the financial world, the relationship between risk and reward is often expressed as an expected return. High-risk investments, such as stocks, can offer higher returns than low-risk investments, such as bonds. However, this does not mean that every high-risk investment will yield high returns or that low-risk investments will never yield high returns. Ultimately, the level of risk you are willing to take depends on your own risk tolerance and financial goals.
The main risks in traditional markets
There are several types of investment risk. What do they have in common? They can all lead to a partial or total loss of capital. Here are some of them:
Market risk is the risk associated with fluctuations in the prices of financial assets due to factors such as economic changes, political events, changes in interest rates, changes in investor sentiment and other exogenous factors that can affect the markets.
Market risk is a risk common to all types of investments, including stocks, bonds, exchange traded funds, mutual funds, currencies and commodities.
Market risk can manifest itself in different ways, depending on the type of investment. For example, in the case of stocks, market risk can manifest itself in a decline in stock prices due to economic factors such as slowing economic growth, declining corporate profits or rising interest rates. In the case of bonds, market risk may be manifested by an increase in interest rates, which may cause the value of existing bonds to decline.
Foreign exchange risk
Currency risk, also known as foreign exchange risk, is the risk that an investor faces when his or her investments are exposed to fluctuations in exchange rates between different currencies. When an investor holds assets denominated in a foreign currency, the value of those assets may rise or fall with fluctuations in exchange rates. For example, if an investor holds shares in a European company and the value of the Euro declines relative to the investor's currency, the value of the investor's shares will decline accordingly.
Currency risk can be a significant factor for investors who invest in foreign securities, engage in international trade or travel abroad. It is important to note that currency risk can impact both short-term and long-term investments.
Liquidity risk is the risk associated with an investor's inability to sell an asset quickly or at a fair price. There may be several reasons why an asset may be difficult to sell quickly. For example, some assets may not be tradable in public markets, such as private placements or unlisted stocks. In addition, markets may be illiquid due to market volatility, economic uncertainty or other factors that may make investors reluctant to buy or sell assets.
Credit risk is the risk that the borrower will not repay a debt or loan as agreed, or at all. This risk can occur when the borrower defaults, i.e., fails to meet its repayment obligations as set forth in the loan agreement.
Credit risk is present in many types of financial transactions, including loans, bonds, credit derivatives and futures. It can affect investors in different ways, depending on their exposure to defaulting borrowers. For example, in the case of bonds, credit risk is the risk that the issuer will not pay the interest or principal due at maturity. Bonds issued by riskier borrowers, such as high-yielding companies or emerging countries, tend to have higher credit risk and therefore potentially higher yields to compensate for that risk.
Operational risk is the risk of loss resulting from errors, systems failures, human error, cyberattacks, natural disasters, regulatory compliance issues, market disruptions, and other unforeseen events that affect the business.
This type of risk can have a significant impact on a company's financial results, especially if it relies heavily on its systems and processes to operate effectively and efficiently. Losses related to operational risk can be direct, such as the cost of repairing or replacing damaged systems, or indirect, such as loss of customers or decline in stock value.
What are the specific risks of digital currencies?
Digital currencies, such as Bitcoin, Ethereum or even other altcoins, have several risks of their own, including:
Volatility risk is one of the main risks associated with crypto-currencies. Prices can fluctuate significantly in a very short period of time. This volatility is caused by several factors, including speculation, economic cycles, technology adoption and geopolitical events.
Speculation is one of the most important factors in the volatility of crypto-currencies. Investors buy and sell crypto-currencies in hopes of making a profit by taking advantage of price fluctuations. This can lead to sharp price increases followed by sharp decreases. As an example, the price of Bitcoin has experienced considerable volatility over the years. In 2017, its price increased by more than 1,000% in a matter of months, from under $1,000 to over $20,000. However, this rapid increase was followed by a precipitous drop of more than 80% in 2018, bringing the price of Bitcoin to less than $4,000.
Digital assets are based on a disruptive technology: blockchain. It has the advantage but also the disadvantage of carrying out transactions in an almost instantaneous and irrevocable way. This speed of execution to transfer money without limit and without intermediary attracts, not surprisingly, the greed of some malicious people.
First of all, cryptos are subject to the risk of hacking. Crypto-currency wallets and exchange platforms are often targeted by hackers looking to steal digital assets. Security flaws in these systems can allow hackers to steal crypto without users being able to recover their funds. This is why it is often said "not your key, not your coin" and why it may be appropriate to keep your crypto assets yourself. The wallets are protected by a private key, which is necessary to access the funds. If this is lost or stolen, the user will not be able to access their funds.
Furthermore, crypto-currency users can be the target of phishing, where scammers try to obtain personal information by posing as crypto-currency exchange platforms or wallets.
The risks associated with crypto-currency regulation are real and can have a significant impact on the crypto-currency industry. We already know that some countries have crypto in their sights. Even worse, the Chinese government have recently opted for an outright ban. If other countries decide to do the same, it could affect the adoption and value of crypto-currencies.
This goes hand in hand with regulators potentially imposing excessive regulations on crypto companies, which could slow down innovation and adoption of the technology. Their fear is mainly about the topics of fraud, money laundering and terrorist financing. It's important, too, to note that the risks associated with crypto-currency regulation are not the same in all countries, and regulators are balancing promoting innovation with protecting consumers.
So what are the best practices for dealing with risk when investing in crypto?
Crypto-currencies can make a lot of money, and in a fast way. But these large gains are necessarily associated with a great deal of risk-taking. Here is the beaba to apply to best understand the risks associated with any crypto investment:
Do your own research
The most common mistake made by new investors is to be influenced by the fear of missing an investment opportunity. This is called FOMO, or Fear Of Missing Out. It is better to take the time to research and make an informed decision than to rush into an impulsive investment that could prove costly in the long run. It can never be recommended enough to understand the project, its goals, its team, its history, its market capitalization, its price chart, its community, etc...
Investing money you don't need to live
If you invest money that you need for current expenses, you may find yourself in a difficult financial situation. So be careful not to jeopardize your financial situation in the short term.
Diversify your portfolio
Investing in a single crypto-currency can be risky, as the value of a currency can vary significantly based on factors such as adoption, regulation and competition. By diversifying their portfolio, an investor can reduce the risk of losing value due to an adverse fluctuation in the value of a single crypto-currency.
Furthermore, different crypto-currencies have different purposes and functionality. By investing in multiple crypto-currencies, an investor can take advantage of different long-term growth opportunities, positioning themselves to take advantage of different trends and developments in the crypto ecosystem. Good news, what Ambrosia is offering with its Crypto Baskets.
Rebalance your portfolio
Selling assets that have grown significantly and buying underperforming assets, so that the portfolio returns to its original asset allocation, helps maintain a consistent asset mix. Rebalancing also allows you to adjust your portfolio according to your investment objectives and risk profile.
And for those who find it too time-consuming to keep an eye on the rebalancing and reallocation of their crypto-assets, Ambrosia allows the automation of all these tasks to make your life easier.
Prendre ses bénéfices Take your profilts
If an investor does not take profits regularly, he or she may miss out on opportunities to make significant gains when prices rise sharply, but may also suffer significant losses when prices fall. In addition, by taking regular profits, an investor can realize profits and reinvest them in other investment opportunities, thereby diversifying his or her portfolio and maximizing the chances of long-term returns.
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