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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’re lucky, you’ll make more profit than expected but remember that things may 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 channels and vehicles. 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 product), you are at a higher risk to lose all your eggs if something goes wrong.
This article is intended to provide you with some tools so you can assess and control your risk.
What is Risk
Risk is the possibility of things not going as expected. For example, when you buy a house for investment, there is a risk of the property not increase in value, the seller being a scam, etc.
Some of these risks you can control. For example, you can double check documents and do research to make sure the seller is not a cheat. However, there is no way to guarantee profit since property prices are not in your hand.
They may go 10% up 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: A change in the interest rate will directly affect the value of your investment if you have taken loan money to invest. Plus, debt related investments 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 variable and a drop in the market value will result in a loss.
- Currency Risk: If you have invested in the foreign stock market or own other foreign investments, there is a risk of losing money because of fluctuations in the exchange rate. For example, if the value of US dollar drops relative to Australian dollars, your US stocks will be worthless 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 inflation
Shares and real estate still offer some protection during inflation as companies can always increase what they charge their customers. 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
Risk management is defined as “the forecasting and evaluation of business risks together with the identification of procedures to minimize or avoid their impact.”
Most big corporations have a risk management department with risk specialists who take steps to identify and reduce risks.
How To Measure Risk
After you have identified the potential risks, you can take the help of a few mathematical tools and techniques 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 methods for measurement of risk are standard deviation, beta, alpha, style analysis, value at risk (VaR), and conditional value at risk (CVaR).
Why You Should Reduce Risk
Investment 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. You will not be losing too much money, you will be able to keep your assets safe, and in the end, will have a strong portfolio for yourself.
You Cannot Completely Eliminate Risk
To think that you would not incur any losses and there would be no risk involved in your investment would be naive. You have to look at all aspects.
There may be fluctuation in share prices, interest rates may vary, and inflation may skyrocket. Plus, political, environmental changes may also be a threat. 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 or follow that can benefit you in the long run.
You cannot completely eliminate the risks involved with investing but you can work towards reducing them in order to minimize the losses.
Here are a few ways you can reduce risks:
One of the best ways to reduce risk is to spread your investments over an assortment of channels. 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 investment results in a loss, you will be able to reduce it due to the profit generated by your other investment.
For example, if you invested all your wealth with a single company and the stocks of that company fell by 50 percent, then you would lose half of your savings. However, if you diversify the portfolio, you will be able to mitigate risks.
Diversifications can be of several types. You may choose to invest in stocks belonging to different companies or opt for different industries altogether. Just make sure to stick to an industry you know about.
Stocks, bonds and money market instruments are the major asset classes for investments.
The first thing you need to decide is whether you want to invest for short term or long term.
- Short Term: Is riskier due to high fluctuations.
- Long Term: Is less risky as the market may eventually stabilize.
Some investments require short term planning while some require long term plans. Real estate, for example, requires long term investment as property prices can take a while to increase.
Dollar-cost averaging means to 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 affairs 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 trust funds. They offer diversification and are handled by professionals. However, remember that agents 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 a thorough research regarding all aspects 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.
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 aside as an emergency fund.
Don’t get too greedy and put in more money than you can afford to lose. Don’t play 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. The easiest way to lower the risk in the stock market is to convert some of your capital to cash.
Digital coins, for example, are risky but can offer good results. You do not buy to invest a lot of money in a specific coin. You can invest a little and wait for the value to increase.
Ripple, for example, is less than $0.2 right now. You can buy 100 units for just $20. If the prices increase in the future, you will make a good amount of money. However, if they fall, you will only lose $20 or even less.
Investing Over Time
The market continually fluctuates 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 gains, especially if you have a 10 or 20 year investment plan on your stocks.
There is more profit and less loss in long-term investment compared to short-term investment.
Which Is The Least Risky Investment?
Ideally, you want an investment that offers good returns but with minimal risks. All things considered, in our opinion, the least risky investment is certificates of deposit.
They 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.
Moreover, precious metals are also said to be safe to invest, especially during a recession. Similarly, real estate is also a safe option if you plan to invest for a long period of time. Check out this real estate investment guide for more.
Investing can be a great way to build your wealth over time but financial risk management controls the investment game.
With proper risk management, you will be able to get safe and consistent profits, no matter what the market conditions are.
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Founder of The Modest Wallet, Ricardo is an entrepreneur and investor who enjoys working out, spending time with his family and friends, travelling and creating great content. He’s passionate about helping others achieve their financial goals.