Investing comes with risks. Sometimes those risks are minimal, as is the case with treasury bonds, but other times, such as with stocks, options, and commodities, the risk can be substantial. The more risk the investor is willing to take, the more potential for high returns. But great investors know that managing risk is more important than making a profit, and proper risk management is what leads to profitable investing.
Each investment product has certain risks that come with it, while some risks are inherent in every investment. Here are a few to consider.
Business risk may be the best known and most feared investment risk. It's the risk that something will happen with the company, causing the investment to lose value. These risks could include a disappointing earnings report, changes in leadership, outdated products, or wrongdoing within the company. Because of the large amount of possible risks that come with owning stock in a company, investors know that forecasting these risks is nearly impossible.
Purchasing a put option to guard against a large decline or setting automatic stops are the best ways to guard against business risk.
Some bonds have a provision that allows the company to call back or repay a bond early. They will often exercise this right if they have to pay a higher coupon on an existing bond than what they would have to pay at today's interest rates. Although this will not represent a loss of principal, for investors who rely on a certain coupon rate for their monthly living expenses, this can represent a substantial loss of income.
For those who rely on coupon income for immediate living expenses, investing in noncallable bonds, bond funds, or exchange-traded funds is a solid diversification strategy.
Have you looked at your 401(k) lately? You've likely heard that keeping the appropriate asset allocation is essential to managing risk as you move closer to retirement. Moreover, federal disclosure rules require 401(k) providers to disclose fees associated with investment products.
The younger you are, the more of your portfolio should be allocated to stocks and as you age, bonds will slowly become the dominant investment type. Manage your allocation risk and fees related to investing in your retirement account by investing in a low-fee target date fund. Additionally, ask for the help of a trusted financial advisor if you don't have the knowledge or experience to manage your own portfolio.
Investors in commodities like oil understand political risk. When Iran threatened to block the Strait of Hormuz, investors were concerned that the price of oil would become more volatile, putting their investment at risk. The Haiti conflict and terrorist attacks on oil pipelines have caused artificial volatility to enter oil and other commodity markets. Moreover, issues arising in Southeast Asia pertaining to land claims, as well as the tensions between North and South Korea, have shaken markets in that region.
Socio-political risk is difficult to avoid since most events happen without warning, but having hard and fast exit points as well as hedges are the best way to weather socio-political storms.
Dividend risk is the risk that a company will cut or reduce its dividend. This is not only a problem for those who rely on stock dividends to live on during retirement, but when a company cuts its dividend, it often causes the stock to lose value, as those who were holding it for the dividend move to other dividend-paying names. Reduce the effects of dividend risk by holding a well-diversified portfolio with multiple dividend-paying stocks. If the dividend is the only reason you're holding the stock, sell as soon as is practical after the announcement of the change.
The Bottom Line
Every investing strategy will have risks and managing those risks is how to gain the best performance from your money. Don't reach for higher rewards without first evaluating the risks involved. Seasoned investors know that it's a lot easier to lose money than it is to gain it.