Risk Management Techniques: the fundamentals of investing

Investing in Risky Assets

Novice investors are looking for profits that can given through investing in an asset. The more experienced of investor you are, the more you know about the existence of risk pertaining to these assets. Experienced investors also know that this risk must somehow be manage and controlled to provide the greatest return on investment. What are some these methods for determining this?

Moody's Standard & Poor's and Fitch was made infamous for scandalous credit ratings following the 2008 financial crisis.
Moody's Standard & Poor's and Fitch was made infamous for scandalous credit ratings following the 2008 financial crisis.

1) Ratings

Rating agencies (such as Fitch Ratings, Moody's, Standard & Poor's, Morningstar) monitor and determine the solvency of the issuers of debt, the quality of corporate governance, quality of asset management, etc.

Credit Ratings are the most well known product of rating agencies


Credit Rating:

  • is an assessment of capacity to pay aka a credit rating. A credit rating reflects the risk of defaults on bonds and affects the value of the interest rate on the price and yield debt. A higher rating corresponds to a smaller risk of nonpayment. These ratings sre used by those who do not wish to conduct their own analysis and want to use someone else's opinion to based the inherent risks involved in investing.

These methods are extremely unreliable.There are many scandals connected with the fact that some of the highest reliability rating agencies have been assigned to frankly fraudulent schemes.

For example CalPERS, the largest U.S. public pension fund, filed a lawsuit against the rating agencies Moody's, Standard & Poor's and Fitch, accusing them of embezzling and approving of "wildly wrong, and unreasonably high" ratings.

2) Rebalancing

Rebalancing is the preparation of a portfolio of assets containing both high and low risk in a certain proportion.


This rebalancing strategy is specifically known as a Constant-Mix Strategy and is one of the four main dynamic strategies for asset allocation


For example, 50% of the portfolio may consist of stocks, and 50% - bonds.There when stock prices rise, the shares that have been bought are then sold bonds to restore this ratio.With falling prices of the same bonds, then the bonds are sold and the shares in stocks are bought again to restore the ratio.

3) Averaging

Averaging is a regular purchase of assets at one and the same amount. 

For example, during  the monthly purchase of shares and indices a investor is able to use averaging in a falling market, he can reduce the total cost of ownership of shares in the portfolio. This works effectively only on long periods of time and also requires a belief in the long-term growth stock indexes.

4) The Diversification of investments

Diversification is the addition of assets of different classes, sectors, regions to an investment portfolio.  This is done so that the drop in the value of one asset will effectively offset by a rise of another. 

For example, you can include in a portfolio of shares of companies of Russian, American, European, Asian companies that invest in real estate funds, to buy gold and silver, raw materials, etc. 

The downside of diversification is the reduction of  the overall profitability of the portfolio. 


Warren Buffett once said that diversification "is protection from stupidity and it is useless for someone who knows what to do."

6) Using the fundamental parameters

Using these indicators does not guarantee that you will get a profit. It's just protects you from the risk of an overestimated buy price of the asset's actual value.

For example, such as the P / E (price-to earnings per share), P / BV (ratio of price to book value), dividend yield, and the ratio of rent to property value.  These are examples of fundamental tools and ratios that are used to help determine the actual value of an assets price.

5) Hedging

Hedging is a form of insurance through the purchase or sale, as a rule, of futures market instruments to protect the portfolio against falling asset prices.

For example, you can buy a put option on shares, and add it to the portfolio along with your other investments. You as the investor will have to pay a premium for this option, but in case of falling prices they would be effectively offset by a loss of option.

Understanding stop losses visually:

7) The use of stop orders

This approach involves the installation of automatic orders to sell the asset immediately after its price reduced by the specified value, for example, 10%.Effectively works only on highly markets, such as the stock market.

For Buy Positions: Placing an entry order to sell below the price where you got into the position protects you from additional losses. Placing an entry order to sell above the price where you got in locks in profits.

  • For example, if you have a BUY EUR/USD position at 1.3900, you could place: a stop-loss using a sell entry order (Stop Entry, SE) at 1.3800 OR a limit using a sell entry order (Limit Entry, LE) at 1.4000.

For Sell Positions: Placing an entry order to buy above the price where you got in protects you from additional losses. Placing an entry order to buy below the price where you got in locks in profits.

  • For example, if you have a SELL EUR/USD position at 1.3900, you could place: a stop-loss by using a buy entry order (Stop Entry, SE) at 1.4000  OR a limit using a buy entry order (Limit Entry, LE) at 1.3800.

Learn more on investments today!!!

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