In the world of investing, risk assessment is a process that investors follow to analyse the risks of a potential or active investment with the aim of determining the likelihood of a negative outcome.
Remember, risks aren’t necessarily a bad thing, so long as you perform a thorough risk assessment and do your due diligence. Risks can be costly if you haven’t taken the time to quantify the risk alongside any possible opportunities.
Performing a risk assessment of a potential or active investment is an essential tool for both planning and managing investments. Investors will often compare the perceived risk against the perceived reward to determine whether a particular investment suits their risk appetite.
Failing to perform or incorrectly managing the risk assessment of a potential or active investment can have catastrophic consequences potentially leading to significant losses.
Generally, when performing a risk assessment on a potential or active investment, some important considerations include:
Investors try to balance their portfolio’s level of risk and reward by:
Here you’re concentrating on the qualities and attributes of the entity you’re evaluating. You’re putting them under the microscope, looking at their products, services, team, use case, value proposition, market conditions and competitors.
In conducting a qualitative analysis, your aim is to identify any red flags that may inform your risk analysis. Examples of questions you may ask yourself about an entity include:
Quantitative analysis uses data and models to inform decision making or understand behaviour. You can use it for measurement, performance evaluation or to value an asset.
In the business world, a company might use quantitative analysis to evaluate their sales revenue or profit margins.
In the cryptocurrency space, an investor might be analysing the token supply, token economics or statistical modelling of historical performance, volatility, momentum, market dominance, etc.
Traders might use this type of analysis more as they can use data to develop their models and inform their trading strategies.
This type of analysis can help you to find possible opportunities or spot risks. It’s always important to pair quantitative analysis with qualitative analysis to make a more complete assessment of risk.
A lack of liquidity remains one of the biggest risks to your assets. This simply means you cannot easily turn your assets into cash.
An example of where this might affect an investor is if they find themselves in a financial situation where access to cash is necessary (i.e. they might lose their job, or incur a significant and immediate debt) then converting an asset or assets to cash may be their only option, otherwise referred to as liquidating assets. If an asset that an investor is looking to liquidate has low liquidity, this is likely due to a lack of willing buyers for that asset. This can make it extremely difficult to liquidate the asset, possibly leading to the investor needing to sell the asset to buyers significantly below market price hence reducing the expected cash value return.
In cryptocurrency, we see liquidity risks regularly. If you’re trading a relatively small or niche cryptocurrency, there might be a lack of buyers or sellers in the market meaning it is ‘thinly traded’. This could be because it is listed on a small exchange and/or there is a widespread unwillingness to buy or sell.
Thinly traded cryptocurrencies can have less stability. Without strong liquidity, smaller cryptocurrencies can be affected more by large trades and prices can fluctuate widely as a result.
An illiquid market can also risk a single person or a group manipulating the price for their benefit. Markets with more liquidity and a greater number of traders are generally more resistant to these risks.
Your time horizon will have a significant impact on the investments you choose and the risks or return central to your portfolio.
While some investments may be a good idea at the time of purchase, your time horizon may change. For example, as you approach retirement, your risk appetite and time horizon may alter. You may want to consider transitioning to less risky investments, as you may prioritise portfolio security and increased liquidity.
Without considering likely changes to your time horizon, you can expose yourself to a large degree of risk.
Normally you will need to retain a sufficient surplus of funds that you can access should the need arise. In this regard, it’s important to match your spending pattern with investment selections to avoid the prospect of selling growth assets like shares during a market crash.
There are many other important considerations to risk assessment that you may want to consider depending on your personal situation and the type of investment you’re looking to assess. It’s important to view each investment on its merits and to conduct thorough research into each as you look to perform risk assessments.
It’s wise to do regular risk assessments of both potential and active investments or trades as the level of risk—and your risk appetite—can often fluctuate or change over time.
When performing your risk assessments, it’s important to consider the unique risks of cryptocurrency investment.