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.