What is the risk? How to identify and quantify investment risk

In the process of financial investment, there is always a risk that the portfolio may lose. So what is the real risk and what are the common risks in the investment process for the crypto market? Let's find out in the article below

Core knowledge:

Risk in financial investment can be understood as the degree of volatility compared to the expected return
Standard deviation is the basic tool for measuring and assessing risk, but there are many other methods that are more complex and accurate.
There are two main types of risk in the investment process that need to be identified: systematic risk and unsystematic risk.
In the crypto market there are many different types of risks that need to be carefully considered and assessed through a variety of methods.

What is the risk?

Risk in the financial sector is defined as the probability that actual returns will deviate from expected returns. According to the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns.

In a word, an investment you expect to receive a return of 20% after 1 year. In fact, if after a 1-year period the return is 30% or 10% (greater or less than the expected return) it means the risk has occurred.

Thus, not only is the price falling from the expected return a risk, an abnormal increase in the price without knowing the cause is also considered a risk if according to the above interpretation.

An example can be mentioned is the phenomenon of short squeeze, liquidation of short positions in bulk causing the price to rise sharply. When this happens, it is possible that one whale or large organization has lost money and this can have consequences for many different parties.

How to measure risk?

As defined above, risk can be measured by volatility relative to the expected return. Typically, risk assessment methods are based on historical data and are measured against the standard deviation of expected returns.

The higher the standard deviation, the more volatile an asset (based on historical data) leads to the higher the risk of that asset. To measure standard deviation we can use the STDEV function in Google sheets.

The example above (data from Coinmarketcap for BTC and ETH daily returns from July 1 to August 9) shows that ETH is a riskier asset than BTC during this time period (due to the bias in the price). standard is 0.05 greater than 0.03 of BTC).

ETH's 0.05 standard deviation shows that ETH returns will tend to fluctuate around +/- about 5% around an average return of 1.31% (between 1/7 and 9/8).

In addition, we can evaluate investment performance through the return / risk ratio through the Sharpe index (Sharpe Ratio) which is calculated by the expected return divided by the risk (standard deviation). Also following the example above ETH is the asset with a greater investment efficiency than BTC during this period.

The above is the most basic way to measure the return risk of an asset based on historical data. There are actually many different methods that can be used to assess the level of risk.

It should be further noted that standard deviation is measured based on past data, in the future this coefficient can completely change. Therefore, this method should be applied to asset classes with a lot of historical data. In addition, when assessing the risk of a certain asset, we need to consider data associated with different events and periods to make statistics from which to give an appropriate level of risk.

Types of risks in financial markets

There are two main types of risk to consider in the investment process: systematic risk and unsystematic risk.

Systemic risk

Systematic risk is also known as market risk. This is a risk that can affect most or all of the market at the same time causing prices to move in the same direction (usually down). Often these risks are caused by factors outside the control of individuals or companies.

Some types of systemic risk can be mentioned such as interest rate risk, events in the economy, inflation risk, liquidity risk, etc.

For the crypto market , an example of systemic risk can be mentioned as the bearish price action in the first half of 2022 due to macro-related reasons such as the geopolitical conflict between Russia and Ukraine , causing Inflation escalated, economic difficulties and impacts on the Fed's decision to tighten monetary policy.

Due to the simultaneous impact on all asset classes or certain asset classes, it is quite difficult to limit systemic risk through diversification of asset classes.

Indeed, during the first half of 2022, most asset classes recorded declines such as stocks and bonds, crypto, or even cash due to the negative impact of inflation.

During this period, although gold had a period of increase of 13.6% due to the impact of political conflicts, YTD's recorded profit was only 0.2%.

Therefore, when systematic risk occurs, we need to monitor and evaluate the portfolio carefully and have a plan to rebalance the portfolio continuously across asset classes with potential to increase in the short term to limit risks ( like gold).

Unsystematic risk

Unsystematic risk can be understood as the risk originating from the intrinsic of the asset or the issuing and operating company of that asset.

When unsystematic risk occurs, it usually affects only one or a certain group of assets that are related to the assets subject to unsystematic risk.

For example: Unsystematic risk may occur to a business such as business, competition, profit or financial risk of possible default, leading to the price of shares. this company or possibly the entire industry suffers a decline. However, such risks have less impact on the market as a whole than systemic risks.

Contrary to systematic risk, unsystematic risk can be easily prevented and mitigated based on the method of portfolio diversification .

For example:

In our stock portfolio, there are stocks from many different industry groups: Finance, technology, energy, retail, ...

Assuming that in a period of technology stocks there is a decline but energy is up (like in the first 6 months of 2022), that means that unsystematic risk is already at risk with public stocks. turmeric.

Since the energy stocks class has grown again, at a reasonable proportion, our portfolio can completely avoid the downside risk.

How to determine risk when investing in crypto

Common risks

Crypto also has the properties as a financial asset, so it also possesses the above risks.

In the crypto market, when BTC and ETH have a sharp drop in price, it will have a big impact on all other coins. Therefore, it is now entirely possible to consider the risks associated with BTC and ETH as a kind of systemic risk to the entire crypto market.

Accordingly, some risks to the whole market can be mentioned as follows:

Macro-related risks: Monetary policy from the Fed, geopolitics, legal risks, energy risks, weather (affecting miners),...
Liquidity Risk: Related to leveraged positions, or collateralized BTC & ETH to borrow, etc.
Risks related to technical problems of Blockchain.
…

Unsystematic risks in the crypto market include:

Impermanent Loss: Pay attention to this risk of temporary loss when participating in liquidity provision.
Slippage: Swap trading has slipped, the amount may be received less than expected.
Smart contract: Due to smart contract errors , it is possible that assets will be in danger when sent to different platforms.
Hack/Exploit: Users may experience losses if they deposit on these platforms.
Phishing Attack : Phishing attack from hackers.
…

Measurement method

Most crypto assets don't have long enough price data except for coins like BTC or ETH, so traditional methods of determination (like standard deviation) will have low confidence in most cases.

Therefore, it is difficult to have a definite method to measure risk accurately in the crypto market. Currently, to measure the risks to the token price we can use statistical methods.

A specific example when investing in Bridge array tokens - this is an area with many risks related to hacking/exploit, so it is necessary to do statistics on these data to determine the risk.

Some basic indicators can be listed as the table below:

Out of a total of more than 70 Bridge platforms (according to Quantstamp ), 8 hacks occurred (according to the "demo" statistics above), accounting for a total of about 11.4%. Accordingly, when investing in Bridge, based on past data, we will have about 11.4% chance that Bridge will be hacked.

Future numbers may decrease (because builders have learned from past lessons).

Most of the bridges hacked above are not audited (according to data from Rekt news). And according to the statistical data, when the hack event occurs:

Almost 100% of assets when left in the Bridge will be affected (only a very few cases like Ronin Bridge offer a refund solution for users).
According to statistical data, within 7 days since the hack happened we will lose money if we invest in that token (the loss can range from 10% - 90%)
Over a longer period of time, the tokens of these Bridges could completely depreciate further.
For Thorchain, because the value at the time of being hacked was not too large compared to TVL of hundreds of millions, the price of the second hack also increased. This data when dig deeper may also have certain risks involved.

Thus, we have relatively estimated the risk of being hacked when investing with the Bridge array, some parameters can be added to consider such as the hack/TVL ratio at the time of the incident, or view look at price movements over different time periods to make a more accurate assessment.

It should be noted: For each different type of risk in crypto, we have different statistical and evaluation methods. Currently, the crypto market is still very new and there are no standard scientific methods, so continuous testing and assessment is necessary in determining risk in this market.

Epilogue

Risk is one of the important factors to consider and evaluate regularly in the process of investing in financial markets. Especially when the specific risks are quantified, we will easily observe and monitor to take specific actions with our investment portfolio.