DEFINITION of 'Limited Risk'

Limited risk describes an investment that has a predetermined maximum downside potential, which is usually the initial amount invested. Investors can also manufacture a limited risk by purchasing securities that move in opposite directions.

BREAKING DOWN 'Limited Risk'

Limited risk exposes investors to situations where they are aware, prior to entering the position, of the maximum level of loss they may suffer. A situation with unlimited risk would include selling naked shorts on a stock, where the potential for loss is infinite.

How Limited Risk Works: An Example

An investor might create an investment portfolio with X shares of Company Beta, which manufactures couches. The furniture industry is cyclical, so Company Beta will likely sell more couches during times of economic growth than it will during times when the economy is slow or contracting. Because of this, Company Beta’s shares will decline in value during slow economic times. As an investor, you might want to protect your portfolio from this volatility, or limit your risk.

One way is to buy stocks that are not as sensitive to economic cycles. Sometimes called defensive stocks, they include food, utilities or other industries that sell products that consumers consider necessary. Theoretically, these stocks hold their value during economic downturns. The defensive stocks act as a bulwark, limiting the risk of holding shares of Company Beta.

Another way to limit the risk of an investment is to purchase a put option contract on the shares. Though costly, this would allow an investor to lock in a minimum price at which the shares could always be sold. An investor could also sell a futures contract, promising to sell the stock at a set price at a certain point in the future.

Why Investors Might Want to Limit Risk

Limited risk strategies help protect a portfolio against volatility. It can be especially attractive when an investor has experienced an extended period of gains and wants to lock in some of them. When choosing a limited risk investment, the investor is fully aware of the potential amount he or she could lose. For example, entering into a cash long position in a stock has limited risk because the investor can lose no more than the initial amount invested. Similarly, purchasing option contracts long has a limited risk, as only the initial premium paid for the option can be lost.

Like all investment strategies, limiting one’s risk requires a little planning. However, the security that this strategy provides could make it well worth the time and effort during a period of declining stock prices.

RELATED TERMS
  1. Limit Move

    A limit move acts as a circuit breaker and is the largest price ...
  2. Limit Up

    Limit up is the maximum amount by which the price of a commodity ...
  3. At Limit

    At limit is an order that sets a maximum limit on the buy price ...
  4. Unlimited Risk

    Unlimited risk is when the risk of an investment is has unlimited. ...
  5. Risk Management

    Risk management occurs anytime an investor or fund manager analyzes ...
  6. Beta

    Beta is a measure of the volatility, or systematic risk, of a ...
Related Articles
  1. Investing

    Beta: Know the Risk

    Beta says something about measuring price risk in stocks, but how much does it say about fundamental risk factors too?
  2. Investing

    Beta: Gauging Price Fluctuations

    Learn how to properly use this measure that can help you meet your criteria for risk.
  3. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  4. Investing

    Understanding Risk is Key to Your Investing Strategy

    Here's why considering all types of risk is crucial for a successful investment plan.
  5. Investing

    How AQR Places Bets Against Beta

    Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
  6. Insights

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  7. Investing

    How to Construct a High-Risk Portfolio

    A high-risk portfolio requires finesse and knowledge, but it can produce above-average returns.
  8. Investing

    Build Diversity Through Beta

    In conjunction with stock valuation ratios like the price-to-earnings ratio and the price-to-earnings-growth ratio, a stock's measure of volatility known as beta can help investors build a diversified ...
  9. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  10. Financial Advisor

    Calculating Beta: Portfolio Math For The Average Investor

    Beta is a useful tool for calculating risk, but the formulas provided online aren't specific to you. Learn how to make your own.
RELATED FAQS
  1. What are some common measures of risk used in risk management?

    Learn about common risk measures used in risk management and how to use common risk management techniques to assess the risk ... Read Answer >>
  2. Why are call and put options considered risky?

    Learn why put and call options are considered risky and see how, depending on which side of the contract you are on, you ... Read Answer >>
  3. What Is the Formula for Calculating Beta?

    Learn about beta, how to calculate it, and how it's used as a risk measure with examples that include Apple and Tesla. Read Answer >>
Trading Center