How to Manage Investment Risk
September 24, 2020
One of the most important factors to consider when investing is how much risk to take. This can be difficult to figure out because we tend to be very emotional about our money! We often find that individual investors don’t know how to evaluate risk and are either taking too much risk or not enough to reach their goals. Unfortunately, every investment involves some amount of risk. It is important to understand investment risk so you can invest wisely to achieve your goals and objectives.
What Is Investment Risk?
Investment risk is basically the chance that the actual outcome of your investment will be different from the expected outcome. This includes the possibility of losing some or all of your original investment. The higher the expected outcome or “return” for the investment, the greater the possibility of loss. Some investments have a higher risk and others have a lower risk. There are four main types of investment risk that you should understand when investing: Market, business, interest rate, and inflation risk.
Market risk is the potential for an investment to suffer a loss due to the poor performance of its respective financial market. The stock market is a prime example of market risk in action. When the stock market goes down, most stock investments also lose value.
Business risk is the potential that an investment will lose value due to the business performance of the company. This can be caused by a variety of factors, such as unsuccessful products, poor financial performance, or bad business decisions. For example, if Apple were to reveal that it was leaving the smartphone market, its stock price would probably drop as a result.
Interest rate risk is the potential for rising interest rates to decrease the value of fixed-rate investments like bonds. If you were to purchase a bond with a 4% interest rate today and then a similar bond with a 5% interest rate became available six months later, the value of your bond would decrease.
Inflation risk is the potential that low-yield investments will not keep up with inflation. If the return on your investment is less than inflation, you will be slowly losing money over time through the loss of purchasing power. We often see this with very conservative investors who want to avoid stock market risk and put their money in safe but low-yield investments.
Less common investment risks include liquidity, opportunity, and currency risk. Liquidity risk is the potential that an investment cannot be sold quickly for a reasonable price. Real estate is the main example of liquidity risk. Opportunity risk is the perceived loss associated with assets being tied up in less than ideal investments. By holding on to poor performing investments, you are missing out on the potential return of better-performing investments. Currency risk is the potential for international investments to lose value because of a rising US dollar relative to foreign currencies. This only applies to international investments.
Before you invest, there are several things to consider. First is your time horizon. With a longer time horizon, you may want to take more risk for the potential of a higher return. If you have a shorter time horizon, you may want to invest with less risk. Next is your investment objectives. Do you want your investments to grow for the future? Do they need to generate current income? Maybe you want a combination of growth and income. Answering these questions will help you determine the right balance of risk for your investments.
Risk Management Strategies
Since risk cannot be eliminated, it is important to evaluate and manage risk in your investments. Here are some strategies for managing the different types of investment risk.
Dollar cost averaging is the process of investing a set amount of money at regular intervals. This strategy helps with market risk because you are buying more shares when investment prices are low and fewer shares when prices are high. This is a great strategy for an investor with a long time horizon.
Laddering fixed income maturities is the act of investing in fixed-income securities, like bonds, so that they mature at different times. This strategy helps manage interest rate risk. If you have four bonds that mature in different years, they can be reinvested at various interest rates at maturity.
Diversification involves spreading your funds across a variety of investments. This strategy can help manage business risk. If your money is invested in one stock, you can lose your investment if that business fails. Some prime examples of this are Enron, Lehman Brothers, and Bear Stearns. The stocks of these companies fell to zero when the companies failed. With diversification, any poor-performing investments should be offset by other better-performing ones.
Asset Allocation is the process of diversifying your investments across a variety of asset classes. This strategy involves accepting a certain amount of investment risk and blending different asset classes together to have the best return potential for the chosen level of risk. The downside of this strategy is it does not reduce market risk during extreme downturns.
Tactical Investing is another way to manage investment risk. This type of strategy evaluates the current market conditions to help determine the potential direction of the market. When the risk of a market decline is high, the portfolio allocation is changed to reduce risk. Then, when market conditions have improved, the allocation is changed back to the normal risk level. This strategy helps minimize losses during extreme market downturns but can struggle when the anticipated market direction doesn’t occur.
How Should You Manage Investment Risk?
There is no right or wrong answer to managing investment risk. It is different for everyone and is highly dependent on your risk tolerance, investment goals, and financial situation. Use our investment risk analysis tool to determine your tolerance for investment risk. If you have a longer time horizon, you may want to ride out the market ups and downs using Asset Allocation and Dollar Cost Averaging. On the other hand, if you are retired and using your investments for income, Tactical Investing may be the better option.
Trinity Wealth Management
When it comes to your investments, having a wealth management advisor you can trust is key. At Trinity Wealth Management, all of our advisors adhere to strict fiduciary rules, meaning we put your best interest first. Contact us today to learn more about the different types of risk management and which may be right for you.
The commentary on this website reflects the personal opinions, viewpoints and analyses of the Trinity Wealth Management, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Trinity Wealth Management, LLC or performance returns of any Trinity Wealth Management, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Trinity Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.