What is risk exposure?

Risk is the possibility that an investor will receive a return that is less than their initial investment. Risk exposure is a measure of the amount of potential risk an investor has assumed by making a particular investment.

In financial markets, investors are exposed to both systematic and unsystematic risks.

Where have you heard of risk exposure?

Once you become an investor or trader, you expose yourself to the risk of losing money on investments. Thus, before you start investing your money, it is crucial to determine your risk tolerance in order to choose strategies and make decisions accordingly.

What do you need to know about risk exposure?

An investor’s risk exposure will depend on their specific goals and expectations. There are several ways investors can manage their risk exposure. If they expect a particular stock or market sector to rise in value, investors will increase their investment holdings and their risk exposure in that stock or sector.

Investors who have a higher risk tolerance tend to allocate more of their portfolios to equities and commodities rather than bonds and cash holdings. While a classic 60/40 portfolio allocation would see an investor hold 60 per cent of their portfolio in stocks and 40 per cent in bonds, an investor willing to take on a higher risk exposure might opt for an 80/20 allocation, holding 80 per cent in stocks and 20 per cent in bonds. Conversely, an investor with a low risk tolerance could hold 20 per cent in stocks and 80 per cent in bonds.

Portfolio diversification is a way to reduce risk exposure by spreading investments across a range of asset classes, including stocks, bonds, commodities and other assets. To take a risk exposure example, an average portfolio might hold 20-30 stocks, so that no individual stock accounts for more than 5 per cent of the overall portfolio and a potential crash in a single share price would not have a significant impact on the overall portfolio value. Investors can also diversify holdings across industries and geographic regions to avoid the impact of cyclical declines in particular sectors or economies.

Investors also use hedging techniques to reduce their risk exposure by strategically offsetting investments with other financial instruments such as options and futures contracts to protect their portfolio against losses in the initial investment.

The formula for calculating risk exposure is based on the probability that risk will materialise.

There are several different types of risk exposure:

• Economic. The risk that an economic downturn or recession will bring down asset prices.

• Geopolitical. Political or social events that affect market sentiment.

• Currency. Changes in exchange rates that have an impact on commodity prices or a company’s operations in international markets.

• Operational. The risk that a business will underperform in generating cash flow and profits.

• Liquidity. A lack of buyers and sellers to enable an investor to trade an asset at a price that reflects the true value.