By: Teddy Haines
One of the most important facets of financial management is an investor’s relationship to risk. Any investing requires some risk taking, especially if the investor is determined to see their portfolio appreciate over the long haul. Because of this, there’s no ultimate guarantee that the promise of big gains from the stock market will materialize for someone. However, that doesn’t mean there aren’t steps that can tip the odds in the favor of the prudent investor.
This guide will detail some steps that can be taken to manage risks and maximize an investor’s chances of long-term success. The key to calculated risk-taking in investment is to determine the level of risk that’s acceptable for a given investor and to manage their investment portfolio accordingly — prioritizing higher or lower risk assets based on market conditions and personal needs.
Step 1: Identify Your Risk Tolerance
There’s always different levels of risks for an investor to take with their portfolio, but as much as this may be dictated by personal temperament and preference, there are external factors that should also be kept in mind. These factors will dictate the exact mix of investment options that will make up your portfolio.
The first external factor to consider is the investor’s personal set of goals, or investment objectives. If all one is looking for is a safe place to park their money, then an assortment of low-risk investments are available, and the question of risk management is a simple calculation. However, if one hopes to use dividends as a source of income, whether primary or supplementary — or else buy and sell an asset that appreciates in value — then courting additional risk will become a part of one’s investment strategy. These investment strategies carry different risk levels, with capital gains likely proving riskier than dividends, and these differences should be kept in mind as one assembles a portfolio.
One other factor that different investment goals dictate is one’s time horizon, which is the length of time that an investor intends to hold their investments. A capital gain strategy will inherently have a shorter time horizon than dividends, since selling off an asset when the time is right is the purpose of such investing.
Another determinant of time horizons is age, with younger investors being more likely to shoulder bigger risks due to having more time to potentially make up losses. This well-worn chestnut isn’t the whole story, however. Younger investors may face more immediate demands on their resources, such as buying a house or a car, and these will dictate a shorter, more conservative investment pattern. Conversely, an older investor with a long life expectancy may find they have a lengthy retirement ahead of them, and some more aggressive investment may prove necessary to tide them over. As Forbes once observed, retirement isn’t the finish line.
A final criterion to keep in mind is one’s overall wealth level. This is self-explanatory, as an investor with more money can put more of it at risk on the stock market, although nobody should succumb to complacency. Self-examination of these factors should help determine how much risk an individual investor is willing to tolerate, although the fact that many of them change over time shows the need for flexibility more than anything. Few considerations are permanent ones.
Step 2: Diversify Your Investments
Keeping in mind that certain assets carry more intrinsic risk than others, investment balance is important regardless of the risk threshold. What will differ based on the riskiness of one’s financial management is the exact balance between safer assets and more temperamental ones.
Investopedia classifies a number of different investment types into a pyramid based on the general risk involved in each:
This pyramid is useful as a general guide to help an investor manage the mix of assets in one’s portfolio based on risk management. The frequency with which one adjusts can vary as much as the portfolio itself does. But the structure reminds us that a foundation of safer assets provides a foundation of sorts, hedging against riskier options or futures.
As intuitive as this observation is, it’s important not to see this as a balanced structure and attribute equal weight to the investments at the summit. Those high-risk assets should consist of whatever disposable income remains after safer investments have been made, so that their loss won’t cripple an investor’s finances.
That said, the usefulness of the pyramid is its modularity, and so long as some stable equilibrium remains, the balance between the three sections can be adjusted based on one’s risk tolerance, personal preferences, and the needs of the moment. Again, the ability to react intelligently is the most important consideration when managing risk.
Step 3: Conduct Due Diligence
As useful as the investment pyramid is, it’s only a generalization based on the nature of the broad investment categories. The viability of an investment will always be something to judge individually.
The major pitfall to avoid here is mistaking high-risk investments as being safer than they are. There are several different kinds of risks bound up in the act of investment, but the main one to be wary of is the simple risk of depreciation, where individual problems or broader issues in the market result in an investment losing its value. With this in mind, the basic measure of how risky an investment can be is the amount of money one stands to lose in a worst-case scenario. This margin can vary widely depending on particular assets, with safer investments like bond funds offering less risk of depreciation than, say, futures contracts, where large and sudden losses are not unheard of.
For investigation of individual stocks or other financial instruments, research platforms like Fidelity or Scottrade offer a wealth of useful information about particular companies, industries, and the broader market. Inspecting an entire portfolio in this manner would be prohibitively time-consuming, of course, so a useful heuristic to follow is the reports of other analysts. Ideally, reading other reports about investments will yield not only general prognosis, but also the reasoning behind them, which will allow an investor to make judgment calls based on the evidence rather than following advice blindly.
The level of research and due diligence an investor will conduct is naturally going to depend on the amount of spare time they can devote to financial management. Because of this, one’s willingness to either scrutinize the fundamentals personally, or to defer to experts will vary. That said, the right amount of vigilance can alert an attentive investor to brewing troubles before they face losses, and is an important part of any risk management strategy.
Step 4: Manage Expectations
As powerful a tool as the stock market it, it’s no financial panacea. In addition to the ubiquity of risk, one also needs to accept that immediate gratification is a beguiling illusion rather than something investment can realistically deliver.
Accepting that the stock market isn’t an avenue to getting rich quick is the first thing to keep in mind in order to maintain perspective. If earning billions in investments were so easy, we’d all be Warren Buffett. While acknowledging that, there’s a more grounded temptation that also exists — that of beating the market, and seeing one’s chosen investments outgrow the stock market as a whole. This is a tempting goal to shoot for in large part because there are certain famous investors who do seem to manage this feat; Mr. Buffett being the most famous. If he and others succeed, then it should be possible for anyone making similar decisions to replicate that success.
Unfortunately, this isn’t a realistic vision to follow for the average person. For one thing, superstar investors like Buffett and Carl Icahn don’t invest in the same way that less wealthy people do. The immense capital at the disposal of investors like these simply doesn’t follow market trends, it helps shape them, often accruing enough influence to steer company policy, or else attracting smaller investors through their star power. A common investor won’t have the means or the notoriety to match this sway, so beating the market in this manner isn’t a workable strategy.
By ignoring the siren song of beating the market, an investor will be able to see it more clearly.. With this perspective, one can avoid risks that might have otherwise ensnared them.
Ultimately, risk is a function of awareness and random chance. In terms of financial management, only one of these things can truly be controlled. An investor can never be certain beforehand if a risky investment will perform excellently, go bust, or fall somewhere in between. What they can know is how uncertain particular investments are, and how much riskiness is affordable given their situation.
By following these guidelines, an investor will be able to manage risk by maximizing their awareness of their own circumstances and how those relate to the broader market. In cultivating that awareness, one can harness just the right amount of risk to prosper.