Key Principles of Managing Investment Risk

Investments can help you maximize your financial portfolio, and yet most carry some risk. This risk ranges greatly, and individuals differ in the amount of risk they can and should carry. Of course, taking this risk is what allows people to make money on their investments. It is important for each person to manage risk wisely to meet his or her personal goals.

Before one understands how to manage risks, he or she needs to understand the types of risks that occur in the market. Even investments that are insured still carry some risk in the form of losing buying power or inflation risk.

The Financial Industry Regulatory Authority (FINRA) identifies two main types of risks. One is the aforementioned inflation risk. In this case, you may lose money when high inflation occurs. For instance, let’s say that you place your money in an FDIC-insured certificate of deposit (CD) at the bank. You know you will get that amount of dollars back, so you do not have the risk of not getting anything. However, if high inflation occurs, that money may be worth much less. In addition, you will not have the money available as buying power to spend on other potentially lucrative investments.

The second type of risk is that of losing money.  This is fairly straightforward. You may invest in a business that is earning great returns only to find that the business fails and your money is lost.

When managing risk, it is important to know how much risk you are willing to take. First you need to think about the money that you need and can afford to lose. Someone who is using money to build a retirement will manage their risk very differently from a millionaire with extra money with which to “play.” Know what your goals are with respect to your investments. Do you want something that is very secure? Do you want to take some more chances? Be careful about being blinded by greed by sparkly, high-yielding and seemingly foolproof investments.

Some investors are not sure how much risk to take. There are different factors to consider. First think about your age. If you are younger, you may have more time to make up for losses. Consider your goals and how much time you have in which to reach them. You also need to think about financial responsibilities. You do not want to miss your mortgage payment because the risk did not prove profitable. Other financial resources can also be considered.

One key way to manage risk is to diversify. You do not want to place all of your money in a single investment, no matter how secure it may seem. Some investments have provoked images of the “unsinkable” Titanic, only to hit a virtual iceberg and sink, taking their investors with them. Some will choose stocks and other investments with a wide range of risk. They may choose a few that are very high risk but which can yield extremely high gains. Others will choose funds that already contain a lot of different investments but have historically shown a decent return. The exact combination of stocks and investments that you choose will be dependent on how much risk you wish to carry. You can carry all different types of investments such as stocks, bonds and cash investments.

Diversifying can also help protect you against certain types of risks.  For instance, you may face currency risk when investing in foreign markets. You may want to diversify across different countries in order to avoid a problem should a currency rate change in a manner that is unfavorable. You will also avoid sociopolitical risk.

It is important to carefully monitor your investments to help avoid unnecessary risk. The changes in markets can be quick or slow but certain trends do occur. These include secular, cyclical and seasonal changes. Keep abreast of how your portfolio is performing, and do not be afraid to make changes.

It is also important to understand the principles of “sunk costs.” Some people stick with an underperforming investment because of the money they have already sunk into it, hoping for an unlikely turnaround. The money you have spent is gone. You must evaluate each investment from the current time on and try to avoid emotional but unintelligent decisions.

You cannot manage your risk if you do not understand the risk of the different investments. Although stocks can be volatile and not everything can be predicted, good research can go a long way in helping you evaluate the risk of a certain investment. For instance, with stocks you need to look at the historical performance of the stock. You can look at the company documents such as the annual report on form 10-K. Consider their financial statements and prospectus, which contains their risk factors. A rating service such as A.M. Best Company, Inc., Dominion Bond Rating Service Ltd., and Egan-Jones Rating Company; Fitch, Inc. can help you evaluate whether the companies can meet financial obligations. Look at where it has been and its volatility in the past. Also consider transaction fees as well.

When looking at bonds, consider default risk as well as the need to redeem it before maturity.  Consider how an increase or decrease in interest rates may affect the true value of the bonds. With cash, you need to consider inflation.

Many choose to gain some assistance when making investments in the form of a financial advisor. They can help you assess the risks of various stocks and build a portfolio that allows you to reach your goals. This may be a great consideration.

Investing money is a great way to earn returns that can secure your financial future, but you must be careful to watch your risk. Spend the time and effort to manage your risk effectively.