Risk management strategies for volatile markets

Patrick McFadden, CFP®, CIMA® CPM® | November 19^th 2022

Understand the concept of risk

Any investor worth their salt knows that understanding risk is essential to success in the stock market. That's why, in volatile markets like the one we've seen throughout 2022, it's more important than ever to have a solid risk management strategy in place. By understanding the concept of risk and how to mitigate it, investors can protect their portfolios from severe losses. There are many different risk management strategies out there, and the right one for you will depend on your individual goals and objectives. But whether you're looking to reduce your exposure to risky assets or simply want to take a more cautious approach, understanding risk is the first step. So don't delay - start learning about risk management today.

The different types of risks investors face when the market is unstable

In unstable markets, investors face many different types of risks. Perhaps the most well-known is the risk of market volatility, where prices can rise and fall rapidly, making it difficult to predict future values. This type of risk is especially prevalent in election years when macroeconomic uncertainties and international conflicts can lead to sudden shifts in the market.

When the stock market is volatile, investors face a variety of risks. Some of these are general market risks that affect all investors, while others are specific to individual stocks or sectors. Investors can use various strategies to manage these risks, including diversification, hedging, and active management.

Market risk is the risk that the value of an investment will decline due to general market conditions. Investors cannot eliminate this risk, but it can be reduced through diversification. Investors can minimize their exposure to any particular market by investing in various asset classes.

Sector risk is the risk that the value of an investment will decline due to problems in a specific sector of the economy. For example, investments in the energy sector may be more volatile during geopolitical unrest. Investors can hedge against sector risk by investing in industries that are not correlated with each other. For example, an investor might invest in energy and healthcare stocks.

Individual stock risk is the risk that the value of a particular stock will decline. This risk can be minimized by diversifying one's portfolio across several different stocks and indexes. Active management is another strategy that can be used to manage individual stock risk. This involves constantly monitoring the performance of individual stocks and buying or selling as needed to maintain a desired level of risk, but this can be detrimental to overall performance when taxes and fees are accounted for.

The pain we feel from loss is far greater than similar gains achieved

According to investment experts⁽¹⁾, the pain we feel from loss is far greater than similar gains achieved. This important principle is known as loss aversion and plays a big role in investor psychology. When volatile markets, investors tend to focus on preventing losses rather than making gains, which can lead to suboptimal decisions that ultimately hurt their portfolios. That's why it's so essential to understand loss aversion when developing risk management strategies for volatile markets. By being aware of our inherent biases, we can make better choices that protect our capital in good and bad times.

Examples of risk management strategies for volatile markets

Volatile markets can be a challenge for even the most seasoned investors. However, it is possible to navigate these waters successfully by employing risk management strategies. One key strategy is diversification, and by investing in various assets, you can mitigate the risks associated with any particular security.

Another strategy is to use stop-loss orders, which automatically sell a security once it reaches a certain price point. This can help to limit losses in the event of a market downturn. Finally, hedging can be an effective way to protect against market volatility. Investing in securities that move in the opposite direction of the overall market can offset potential losses.

While these strategies can be helpful, it is also essential to work with a financial advisor who can provide guidance and support during periods of market turbulence.

The role of an investment advisor in risk management during times of volatility

Investment advisors play a critical role in risk management during periods of market volatility. One of the key strengths of an investment advisor is their ability to help the client keep their eyes on the investment policy rather than on the day-to-day fluctuations of the markets. By focusing on the long-term goal, the investment advisor can help the client avoid making panic decisions that may lead to losses. The advisor can also help to develop a plan for managing risk, which may include hedging strategies, stop-loss orders, and diversification. By working with an investment advisor, clients can navigate volatile markets with confidence.

Closing thoughts on the importance of risk management in today's markets

Volatile markets can be a challenge for even the most seasoned investors. However, it is possible to navigate these waters with discipline by employing risk management strategies⁽¹⁾. By diversifying your portfolio, using stop-loss orders, and hedging your investments, you can protect your capital in good and bad times. It is also essential to work with a financial advisor who can provide guidance and support during periods of market turbulence. Focusing on your investment objectives is the best way to ensure that you come out ahead in today's markets.

DISCLOSURES

(1) INVESTOPEDIA - INVESTING: various sources and research studies

The opinions expressed herein are solely those of Patrick K. McFadden and are subject to change without notice. The information set forth herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of market segments or strategies discussed. Investing in securities is speculative and entails risk, including potential loss of principal. The opinions of the author expressed herein are subject to change without notice and do not necessarily reflect those of the Firm. Additional information is available upon request.