Financial Risk: What Is It?

#38. Trading

Financial Risk: What Is It?

Cryptocurrency investments are always associated with a certain amount of risks. It entails understanding you may have either full or partial financial loss of funds, i.e. the probability of not receiving the expected profit in case of unfavorable conditions or after having made a wrong investment decision — this counts as financial loss.
In this article, we’ll cover the types of risks that exist, how to analyze and assess them, and how to manage risks when investing in digital assets.

Types and Classification of Risks

Types and Classification of Risks

Financial risks associated with the crypto economy sector, depending on the factors of their possible occurrence, can be divided into several types:

  1. Political – Financial risks related to changes in the political environment within the global community
  2. Economic – Risks caused by unfavorable changes in the global economy
  3. Legal – Risks associated with the uncertainty of the legal status of cryptocurrency in the world, and regulatory restrictions

Risks can be classified based on their possible consequences, as such the following types are identified: 

  1. Acceptable risk – Based on making investment decisions in which possible losses will not exceed the amount of expected profits.
  2. Critical risk – The possibility of partial loss of investment. This type of risk initially exceeds the expected profit.
  3. Catastrophic risk – The prospect of completely losing all investments without any possibility of profit.

Considering the financial consequences of crypto investing, there are two main types of risks:

  1. Financial loss – The probability of losing all or part of the investment due to external factors or subjective decisions.
  2. The prospect of missing out – The chance of missing an opportunity to make a profit in case of inaction.

Risks in the crypto economy can be classified differently, with each case highlighting their nature of occurrence or their consequences. But in general, several main factors provoke risks, which are based on the specifics of cryptocurrency:

  1. Malware – The use of ransomware, various viruses and phishing can lead to partial or complete loss of assets.
  2. Hacking attacks – The probability of losing investments due to cyberattacks on wallets, crypto exchanges or other cryptocurrency storage services.
  3. Lack of legal framework for crypto insurance – Inability to recover losses due to lack of insurance for crypto investments.
  4. Closure of crypto exchanges or their bankruptcy – Technical problems at exchanges or their profitability could cause them to be closed, leading to the loss of all digital assets in their accounts.
  5. High volatility of digital assets – Crypto volatility can result in substantial financial losses.
  6. Erroneous transactions – Errors in the funds transfer process lead to irreversible loss of money.
  7. Loss or theft of secret cryptocurrency wallet access codes. 
  8. Hypothetical possibility of the crypto market crash. 

Risk Analysis and Assessment

Risk analysis and assessment

Identifying risk factors and assessing them plays a considerable role in making investment decisions. Therefore, the need for risk analysis is one of the priority tasks of a successful crypto investor.

A comprehensive approach to risk analysis is the most effective. For its implementation, it’s necessary to collect a maximum of information that can positively or negatively affect investment decisions. You will need to consider the following factors:

  1. Qualitative risk analysis – It allows you to identify and designate the likely types of risks of a particular project, as well as determine their level of impact on the success of the investment. At this stage of risk analysis, it is important to consider all factors that somehow affect or may affect the project.
  2. Quantitative risk analysis – A numerical determination of the amount of profit or investment loss. Mathematical statistics can be the basis for such analysis.
  3. Probabilistic risk analysis – Based on studying the risks of similar crypto market projects, taking into account the political and economic situation and their probable impact on a specific investment project.
  4. Expert risk analysis – The study of investment projects, collection and analysis of information by disinterested third-party specialists.

Applying different risk analysis methods to the same project increases the chance of considering all possible options and developing an effective investment plan.

Risk Management Methods

Risk Management Methods

Even applying all types of analysis and risk assessment will not be enough to reduce the probability of losing investment by 100%. That is why following the basic investment principles will help lessen the likelihood of losses. The main investment rules can be the following:

  1. Risk should be worth the profit.
  2. An investor must never risk all of his capital at once.
  3. The total amount of invested capital should not exceed the expected profit, that is, you should not risk everything for the sake of a minimum.
  4. All efforts should be directed at anticipating the consequences of risk.

So, observing the basic rules, you can use a variety of ways to reduce risk. The key methods of risk management are:

  1. Avoidance – Implementing this method means refusal to invest in risky projects and with unreliable partners and new innovative projects, whose efficiency is questionable.
  2. Localization – When identifying the vulnerabilities of investment projects, the localization method is one of the most effective ways to reduce risk. Separation of investments involved in a dubious project from the main wallet will significantly reduce the probability of complete loss of assets.
  3. Diversification – Dividing investments among several relatively small projects is more likely to yield greater returns than investing all assets in one large project.

A detailed analysis and risk assessment of any crypto project is the key to profit. Understanding the vulnerabilities of a project and its dependence on socio-economic and political events will help reduce the likelihood of losses. And adhering to the basic investment principles and using risk management techniques will help avoid losing assets.