The Modest Wallet is a free digital publication delivering its readers simple personal finance solutions. We regularly partner with brands that have products and services that will help our readers. Some of the links in this post are from our partners. How we make money.
It does not matter what kind of investment you make — stocks, real estate or even a new business — there is always a certain level of risk involved. You will not always get the expected returns. If you invest correctly, you’ll make more profit than expected but remember that things can go downhill as well.
Managing risk is essential for any investment strategy. An effective way to control risk is by spreading your investments across different vehicles, industries and sectors. This is very important because if you have all your eggs in one basket (whether it’s the stock market, real estate or any other type of investment), you are at a higher risk to lose all your eggs if something goes wrong.
This article is intended to provide you with some strategies so you can assess and control your risk.
What is Risk
In financial terms, risk is defined as the possibility of things not going as expected. For example, when you buy an investment property, you run the risk of it not increasing in value, the tenant trashing it, etc.
Some of these risks you can control or mitigate. For example, you can double-check documents and do market research to ensure a property is in a good state before you invest in it. However, there is no way to guarantee a return on your investment since property values over time are not in your control.
Prices may go up 10% within a year, or fall 20% in a few months.
What Are The Kinds Of Investment Risks?
Here are some of the most common investment risks:
- Interest Rate Risk: If you have taken a loan to invest, a change in the interest rate will directly affect the value of your investment. Debt related investment can also be affected. Think of bonds, if the interest rate increases, the market value of bonds will drop.
- Equity Risk: This applies when you have invested in shares. The market value of shares is highly volatile and a drop in the market value will result in a loss.
- Currency Risk: If you have invested in a foreign stock market or you own other foreign investments, there is a risk of losing money because of fluctuations in the exchange rate. For example, if the value of the US dollar drops relative to the Australian dollars, your US stocks will be worth less in Australian dollars.
- Liquidity Risk: There is always a chance that you will not be able to sell the investment when you’d like to. This could be due to a variety of reasons including a lack of sellers and poor market conditions.
- Credit Risk: Credit risk again applies to debt investments such as bonds. If the entity or company that has issued the bond has fallen into financial difficulties and is not able to pay the interest or repay the principal amount then you will suffer a loss.
- Inflation Risk: Inflation is not in your control. Rising prices can affect your cash investments. There is a risk of reduced purchasing power if your investment does not grow faster than the inflation rate. Stocks and real estate still offer some protection against inflation as companies can always increase what they charge their customers or landlords can increase the rent. However, with cash investments, you are at a loss because over time the same amount of money will buy you fewer goods and services.
- Horizon Risk: Your investment horizon may be cut short in unfortunate events such as losing your job. In such cases, you may have to sell investments that you were planning to hold long term and if you must sell at a time when the markets are down, you may lose money.
What is Risk Management
All investments carry some level of risk. So, risk management is defined as the process of identifying the risks involved in a certain investment and then managing that risk in the best possible way. Managing risk can help you reduce loses and achieve your investment goals.
How To Measure Risk
After you have identified the potential risks, you can use mathematical tools and financial models to measure the risk to some extent.
Risk is measured according to the volatility or fluctuations in the price of the unit. The more fluctuation, the higher the volatility and thus the higher the risk.
For example, a stock with high standard deviation experiences high volatility and therefore, a higher level of risk is associated with it. This is also why riskier investments tend to be more profitable.
Some common parameters for measuring risk are standard deviation, beta, alpha, style analysis, value at risk (VaR), and conditional value at risk (CVaR).
Why You Should Reduce Risk
Investing is already a tricky business, you never know when things might take a turn for the worst.
It is always better to be prepared, especially when there are so many risks associated with even the most minor kind of investment.
By working towards reducing or minimizing risk, you will be maximizing opportunities for yourself to invest better. The general idea is for you to make more money, be able to keep your assets safe, and in the end, have a stronger portfolio.
You Cannot Completely Eliminate Risk
To think that you will not incur any losses or that there are no risks involved in your investment, would be naive. You have to look at the bigger picture.
Political factors may cause share prices to fluctuate, or the economic landscape may cause interest rates and inflation to skyrocket. All these things have to be kept in mind before planning any kind of investment.
The bottomline is, you can’t run away from risk but you can reduce it.
Steps To Reduce Risk
There are a few things you can practice to help you in the long run.
As we said earlier, you cannot eliminate your investment risk completely, but you can work towards reducing it in order to maximize your returns.
Here are a few ways you implement today to reduce risks:
One of the best ways to reduce risk is to spread your investments over an assortment of vehicles, industries and sectors. Having all your investment in one place can be quite dangerous because you’re at a higher risk of losing a large part of your investment.
This is where diversification comes into play. It refers to investing in different sectors and using different investment products. This way the overall value of your portfolio will be protected. Even if one of your investments results in a loss, you will be able to reduce it as a result of the profit generated by your other investments.
For example, if you invested all your wealth in a single company and the share value of that company fell by 50%, then you would lose half of your investment in one shot. On the other hand, if you diversify your portfolio, you will be able to mitigate your risk.
Diversification comes in different flavors. You may choose to invest in stocks belonging to different industries within a specific sector, or opt to invest in different sectors altogether. Just make sure to stick to an industry or sector you know about.
Equities (stocks), fixed income (bonds) and money market instruments are typical asset classes for investments. However, you may also choose to invest in alternative investments such as real estate, art, commodities, futures, etc.
The first thing you need to decide is whether you want to invest short term or long term.
- Short Term (trading): It’s riskier due to speculation and high fluctuations in the market (volatility).
- Long Term (investing): It’s less risky as the market tends to be stable over longer periods of time.
Some investments require short term planning while some require long term plans. Real estate, for example, is typically a long term investment as property values can take time to increase.
Investing in non-correlated asset classes is a practice used by investors to balance the returns in their portfolio without the highs and lows. In other words, you generally want to find asset classes that move in inverse ways. When one asset is going down, the other is going up. As a result, the volatility in your portfolio will be a lot smoother.
Dollar-cost averaging means investing a specific amount of money at regular time intervals regardless of market performance. Under this approach, you invest more in shares when the prices go down and reduce your investment when the prices go high. This way the average cost is balanced.
The key to dollar-cost averaging is to choose carefully where to invest. It is best to buy stocks in companies and industries that are expected to grow in the future.
Hire A Professional
Hiring a financial advisor to manage your investments can be pretty helpful. They will manage the whole portfolio for you and help you develop a holistic approach to your finances.
Since they are knowledgeable about different kinds of investments, they will guide you and give you advice on where, when, and how to invest.
Plus, you also have the option to turn to funds. They offer diversification and are managed by professionals. However, remember that advisors will only tell you where to invest. They may not necessarily invest on your behalf and cannot be held liable for your loss.
Time To Buy And Sell
The most important thing about any investment, whether it is the stock market or real estate, is to grab the opportunity at the right time.
Do thorough research regarding all aspects of your strategy before investing. The best time to buy stocks is when the market is falling. This way you will be able to buy good stocks at a lower price. Keep in mind that you should never try to time the market.
Another important thing is to know when to liquidate your assets. If one of your investments is not going as well as expected or going in a loss, then you have to sell in order to protect your money.
You might also want to sell at a profit when the market is doing well. Know what you want to do and when you want to do it to maximize profits.
Invest Only What You Can Afford To Lose
This has to be followed as a rule in all investments. It’s not wise to invest all your savings, always keep a small amount of money in an emergency fund.
Don’t get too greedy and put in more money than you can afford to lose. Don’t view investments like the lottery because it’s a risky business.
Your investment can be very profitable but at the same time can result in losses as well. Invest wisely to protect yourself from incurring a loss.
By position sizing, you limit your exposure. If you come across an investment that is riskier than others, you can choose not to invest in it or invest only a small amount.
A 50% loss on a $1,000 investment would be less damaging than it would be on a $10,000 investment. As a general rule of thumb, you should never risk more than 2% of your capital in one single security.
Long Term Investing
The market fluctuates on a regular basis, and even if the value of a given investment rises and falls during a short amount of time, it will generally gain back any losses over the long term.
Long-term investments actually offer you more stable and consistent returns, especially if you have a 10 or 20-year investment plan on your stocks.
There is more profit and less losses in a long-term investment compared to a short-term investment.
Which Is The Least Risky Investment?
Certificates of Deposit (CDs) are also pretty safe. CDs are issued by banks and offer a higher interest rate than savings accounts. They have specific maturity dates and money cannot be withdrawn before a specified period of time. With CD’s, you are paid interest at regular intervals and once it matures, you can take out your principal amount plus any accrued interest. Because of their higher payouts and safety, CD’s can be a good investment option.
Precious metals are also said to be safe to invest, especially during a recession. Similarly, real estate is yet another safe investment option if you plan to invest for a long period of time.
Investing can be a great way to build wealth over time, but investment risk management controls the investment game.
With proper risk management, you will be able to get safe and consistent returns, no matter what the market conditions are.
Get our free Stock Market Playbook to learn how to invest your first $500 in the stock market.
Plus our best money tips delivered straight to your inbox.
Ricardo is an entrepreneur, investor and personal finance nerd who enjoys spending time with his family and friends, travelling and helping others achieve their financial goals. Ricardo has been quoted as a personal finance expert in several online publications including Healthline, Bankrate, GOBankingRates, MSN Money, Yahoo Finance, U.S. News & World Report, Forbes and USA Today.