Investing can be a rewarding way to grow your wealth, but it comes with risks that you need to understand. Different types of risk can affect your investments in various ways, and being aware of them is a core aspect of making informed decisions. In this guide, we’ll explore common types of investment risks and practical strategies to mitigate them effectively.
Table of contents:
Investment Risk Categories
Investment risks come in various forms, including financial risks, portfolio risks, asset risks, and behavioral biases.
Financial Risks Types
Financial risks are all about the chance of losing money. Here are some common ones:
- Market risk: When the overall market goes down, your investments might too. This risk arises when you invest in stocks, for example.
- Credit risk: If someone you’ve loaned money to can’t pay you back, you could lose out. Exposing yourself to this risk is possible by buying bonds.
- Liquidity risk: sometimes, you might struggle to sell your investments quickly for a good price. This one occurs when you buy an asset with very little volume on the exchange.
Portfolio Risks
These risks are tied to how you’ve spread out your investments:
- Concentration risk: Putting too much money into one thing can be risky. If you invest all your money in one stock and that company goes bankrupt, you could lose everything.
- Diversification trade-off: By spreading your money around different investments, you can lower your return from the great idea. For instance, you did a lot of research and bought shares of a business. Later, you decided to sell part of your investment just to diversify your portfolio. In the case where the investment was intended for the long term, you might miss out on further returns.
- Non-diversifiable risk: Some risks are inherent in the entire market going up and down. Changes in interest rates or overall economic conditions affect all investments, irrespective of how diversified your portfolio is.
Asset Risks
Different types of investments have different risks:
- Stock market risk: Investing in stocks means your money can go up or down depending on how well the companies you’ve invested in are doing.
- Bond risk: Bonds can be affected by changes in interest rates and how likely it is that you’ll get your money back.
Other Risks
There are also risks tied to how people make decisions:
- Loss aversion: You might sell your investments at a loss just to avoid seeing the value drop further, even if it’s better to hold onto them.
- Confirmation bias: You might only pay attention to news that supports your belief that a certain investment will do well, ignoring signs that it might not.
Mitigating Investment Risks
Diversify Your Investments
To mitigate asset risks associated with investments, diversification is key. Investing solely in stocks exposes you to the fluctuations of individual companies and market volatility. By diversifying your portfolio with a mix of asset classes, including bonds, real estate, and possibly commodities, you can spread out your risk. Bonds can act as a stabilizing force in your portfolio, offering income and capital preservation, especially during periods of stock market volatility.
Additionally, consider investing in low-cost index funds or exchange-traded funds (ETFs) that provide broad exposure to various sectors of the market, further reducing your reliance on any single investment. Regularly reviewing and rebalancing your portfolio to maintain your desired asset allocation can also help mitigate asset-specific risks over time. I share my approach to diversification in this article.
This technique will help you with market risk, concentration risk, stock market risk, and bond risk.
Be Mindful of Behavioral Biases
Be aware of common behavioral biases that can influence investment decisions. By recognizing these biases, you can make more rational and informed investment choices, rather than letting emotions drive your decisions. In my first years of investing, I watched tens of videos and read articles to confirm my thesis for buying a particular stock.
However, this approach didn’t help dissuade me from investing in the stock because I was mostly paying attention to like-minded videos. Nowadays, I am trying to read articles with opposing opinions and debate the reasons not to buy, using facts or considering them as risks.
This technique will help you with market loss aversion, and confirmation bias.
Stay Informed and Do Your Research
Stay up-to-date with market trends, economic developments, and changes in investment regulations. While investing in bonds or even buying a share of the company, cautiously investigate the debt structure. Credit ratings and the company’s balance sheet are valuable sources for assessing debt.
Credit ratings are assigned by credit rating agencies such as Standard & Poor’s (S&P) and Moody’s Investors Service. These ratings can help you gauge the company’s creditworthiness and its ability to repay debt obligations.
The balance sheet is typically included in quarterly or yearly reports available on the company’s investor relations page. It provides detailed information about the company’s current financial position.
By leveraging credit ratings and examining the balance sheet, you can mitigate credit risk and make more informed investment decisions.
Choose investments that are traded on highly liquid markets with active trading volumes to reduce liquidity risk. Assets traded on major stock exchanges or highly liquid bond markets are generally easier to buy and sell quickly without significant price impact.
My Approach to Risk Management
My approach to managing investment risks involves a comprehensive strategy focused on research, portfolio management, and risk awareness. I try to eliminate or mitigate risks through research and strategic portfolio construction. However, recognizing that some risks are inherent and unavoidable, I document these risks and incorporate them into my investment evaluation process.
For example, I continuously monitor metrics related to loan quality and deposit composition for my bank investments, while also applying additional discounts to account for operational, regulatory, and macroeconomic uncertainties. By regularly revisiting and validating my investment ideas, I ensure that my portfolio remains resilient and adaptable to evolving market dynamics.
Conclusion
In conclusion, awareness is paramount when it comes to managing risk. Investing without a clear understanding of potential outcomes can be harmful. While higher returns often require taking on more risk, it’s crucial to recognize that risk is a measurable and manageable factor that can be mitigated but never entirely eliminated.
For instance, investing in stocks entails stock market risk. However, avoiding stocks altogether exposes investors to the possibility of missing out on the potential returns of the stock market. Therefore, rather than attempting to eliminate risk entirely, it’s better to employ risk management strategies to navigate the complexities of investing effectively.
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