What Is Limited Risk?
The term-limited risk refers to an investment strategy that caps the potential amount of loss an investor can face—usually, the initial amount invested. This means the investor knows how much they could lose in the event market conditions go south.
Investors who employ this strategy do so by purchasing securities that move in opposite directions. This strategy basically provides investors with a form of insurance or protection against possible losses.
- Limited risk is an investment strategy that puts a ceiling on the potential loss an investor can face.
- The maximum an investor usually stands to lose is the initial investment.
- Limited risk involves purchasing stocks that move in the opposite direction—such as defensive stocks—or put option contracts on the shares.
How Limited Risk Works
Limited risk exposes investors to situations where they are aware of the maximum level of loss they may suffer before they even enter into a position. This type of strategy puts a ceiling on the potential loss, helping protect a portfolio against any volatility in the market. It can be especially attractive when an investor has experienced an extended period of gains and wants to lock in some of those positive returns.
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. These stocks theoretically hold their value during economic downturns.
Another way to limit the risk of an investment is to purchase a put option contract on the shares. This avenue may sometimes be costly, but it allows 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.
As noted above, an investor who chooses a limited-risk investment is fully aware of the potential amount they could lose. For example, entering into a cash long position in a stock has a 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.
Just like any other investment strategy, investors should do their research and plan in order for the limited risk to work in their favor.
Limited vs. Unlimited Risk
Unlimited risk is the opposite of limited risk. It occurs when the potential for losses is not capped. As the name suggests, there is unlimited potential for losses on a particular investment. While investors may lose just the value of their initial investment with limited risk, unlimited risk means they can lose much more than that—whether it's just a small portion, or the entire investment itself. A situation with unlimited risk would include selling naked shorts on a stock, where the potential for loss is infinite.
Example of Limited Risk
Let's say an investor creates an investment portfolio that includes shares of Company Beta, which manufactures couches. Since the furniture industry is a cyclical one, Company Beta will likely sell more couches during times of economic growth than it will when the economy is slow or contracting.
Because of this, Company Beta’s shares will decline in value during slow economic times—something that the investor should be aware of when they invest in the company. The investor will probably want to protect their portfolio from this volatility by purchasing defensive stocks. As mentioned above, economic downturns don't necessarily affect the value of these stocks, so they'll act as a bulwark, limiting the risk of holding shares of Company Beta.