What is 'Financial Exposure'

Financial exposure is the amount that can be lost in an investment. For example, the financial exposure of purchasing a car would be the initial investment amount, minus the insured portion. Knowing and understanding financial exposure, which is just another name for risk, is a crucial part of the investment process.

BREAKING DOWN 'Financial Exposure'

As a general rule, investors are always seeking to limit their financial exposure, which will help maximize profits. For instance, if 100 shares of a stock purchased at $10 a share appreciated to $20, selling 50 shares would eliminate the financial exposure. The only risk going forward would be to the profit made as the principal amount was already sold. Conversely, if the stock decreased from the original purchase price of $10 to $5 per share, the investor would have lost half the original principal amount.

Financial exposure does not only apply to investing in the stock market. Financial exposure will occur anytime where the participant stands to lose any of the principal value invested. Purchasing a home is an excellent example of financial exposure. If the value of real estate declines and the homeowner sold at a lower amount than the original purchase, a loss on investment would occur.

Reducing Financial Exposure

The simplest way to reduce one’s financial exposure is to put money into principal protected investments with little to no risk. Certificate of Deposits or savings accounts are two ways to drastically reduce financial exposure. Both investments are guaranteed by the FDIC, up to the qualified coverage amounts. However, with no risk comes very little return on investment. Also, with having no financial exposure also leaves a conservative investor subject to other risks, such as inflation risk.

Another way to reduce financial exposure is to diversify among many different investments and asset classes. To build a less volatile portfolio, an investor should have a combination of stocks, bonds, real estate and other various asset classes. Within the equities, there should be further diversification among market capitalizations and exposure to both domestic and international markets. When a portfolio is successfully diversified among many asset classes, it should reduce overall volatility. If the market as a whole goes down, non-correlating asset classes will reduce the downside.

Hedging is another way to reduce financial exposure. There are many different ways to hedge a portfolio or an investment. Oil prices were skyrocketing and causing the airline industry to raise ticket prices and shrink margins, Southwest Airlines Co. (NYSE: LUV) purchased oil future contracts at lower prices in anticipation as a hedge. While its competitors were struggling to compete with the high price of oil, Southwest was able to maintain lower ticket prices. This caused consumers to flock to the lower priced tickets regardless of brand loyalty.

An investor can hedge in the stock market by using options, inverse ETFs or bear-oriented funds. Gold is one of the most common hedges, usually appreciating with an inflating dollar or volatile markets.

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