How to minimise risk in investment…
I understand that there are many specific factors which may influence investment risk and that these can only be determined by examining individual investments. However, there are some continuities concerning risk and some ground rules which, if followed, will somewhat reduce said risks. At this point I must stress this guide is NOT ‘how to eliminate investment risk’! Every investment carries risk, and any company offering a guaranteed return is fraudulent. Having said this, there are straight forward ways to reduce the risks:
- Knowledge- Gaining a thorough understanding of the area you intend to invest in is paramount! Alastair Robertson (Corporate Finance Senior Associate) suggests that ‘a combination of thorough quantitative and qualitative analysis is necessary. Despite it’s age, Graham and Dodd’s theory holds true today and should allow an investor to discover undervalued stocks if the necessary research is performed – therefore minimising the risk of losses’.
- Separate your money and your emotion- Keep a clear head, make decisions based on research and intellect not on gut instincts, if in doubt seek a second opinion. Setting realistic targets, limits and ground rules before you start out is a good way to discipline yourself and it helps you to walk away at the right time.
- Diversify your investment – This seems to be the most commonly offered advice. Umair Rauf Danka (Risk Professional) recommends ‘Identify[ing] your risk appetite and diversify accordingly across range of investments with different interdependencies. Brian Neale (Senior Investment Manager) explores a strategy of ‘diversifying’ in detail: There are many different types of risk to consider when investing, but broadly speaking you most likely would be most concerned with correlation and beta. i.e. Diversifying. Correlation and beta refers to the directionality of two (or more) assets. It is expressed as a range from 1.0 to -1.0, with 1.0 being perfectly positively correlated, -1.0 being perfectly negatively correlated, and 0 meaning no correlation. Beta on the other hand, expresses the degree of an assets movement relative to a benchmark. Beta is expressed as 1.0 generally being the value assigned to an index. The higher the beta of an investment, the more variance it will exhibit (relative to a given benchmark). Thus, for example, a stock being tracked against the S&P 500 that has a beta of 2.0 would be expected to move twice the magnitude of the index…so if the S&P is up 10%, you’d expect the stock to rise 20%. Again, in layman’s terms, think about correlation as determining which way an investment will move (up/down/flat) and beta as how much it will move (as compared to “the market”).
With this backdrop, you’d want to avoid a portfolio that consists of securities that are highly correlated and exhibit a high beta. You don’t want all your assets to rise and fall at the same time, nor do you want all of your assets to move two or three times as much as the market. Of course, we all would want our investments to always rise with the market, and with greater magnitude! In reality, however, markets move up and down, and in managing risk you’re more concerned with how bad things get when the markets are down rather than juicing the portfolio to the upside.
So…how to you ensure you are minimizing these risks? The simple answer is to diversify among various assets classes (and to a lesser extent, within asset classes), and that do not have excessive beta exposure. The more asset classes (that are not highly correlated) you add, the more diversification benefit you’ll achieve. There is a limit to the benefits of adding more asset classes (you can become “over diversified”), but in general, think in terms of owning a portfolio of domestic stocks, international/emerging stocks, core fixed income, and cash. This is one reason why ETF’s have become so popular over the last decade; you’re essentially getting the diversification effect of holding all the securities in a given index, while at the same time adding a know amount of beta into your portfolio, and the ability to access various markets
- Minimise Potential ROI – Bryan C Webb advises that the more the potential for gain, the bigger the risk. Thus money markets have low rates but little risk.
- Don’t pay too much! David Collins (Corporate Finance Analyst) suggests that the only risk in investing is paying too much. If your investment turns out worse than expected, you paid too much. Make sure that you invest at a great price, you have less money to lose and more to gain. If the price isn’t great, simply don’t invest.
There are many risks in investment and many strategies for minimising them, this is only scratching surface! Do you think some critical methods for minimising investment risks were missed out? Or do you think that some of those listed are irrelevant? Write your thoughts below!