Risk is arguably one of, if not the most important factor that you need to consider when investing. If risk really is so important (Which it is!) then being able to manage risk is key to investing success. Given the significant impact risk has, the best investors are said to have a clear focus on risk, in which investment risk management can lead to achieving solid returns.
What is investment risk management and why it matters?
There is a lot of promise surrounding returns when people invest. The problem is, it is impossible to predict returns. This is because risk affects the returns on every asset. Therefore, for investors to achieve the returns they desire, they must be able to manage that risk.
When investing, there are methods and strategies to be able to understand and manage that risk. Firstly, it is important to know just what risk management is:
Risk management is the process of identifying and analysing risk so it can be understood and managed in order to minimise its threat and maximise the potential outcomes.
Risk management in investing means being able to understand the threat of risks. It requires identifying the types of risk that may affect an asset and analysing the effect that those risks may have. By evaluating the risks, it allows you to better appreciate the asset, giving you an idea of how it may perform and the potential returns it could really give once risk is factored in.
Investment risk management is useful for putting a clearer focus on risk. It provides investors with a foundation for which they can evaluate an investment and manage the potential risks. By managing that risk, it allows the investor to be able to find the right balance between risk and return. Essentially, investment risk management is the optimisation of risk in order to help investors to maximise their success.
How to manage investment risk
When it comes to investment risk management, there are a number of ways to consider how you can manage risk. These ideas are there to support your investment decisions. They will help to optimise risk to help you find achieve your goals.
Fundamental analysis is the process of assessing a potential investment to understand the underlying factors which affect that asset. It involves identifying and evaluating those factors to be able to understand and determine how successful an investment could be. Whilst you can apply fundamental analysis to almost any asset type, it typically focuses on high-risk assets, such as stocks and shares.
Fundamental analysis requires a thorough evaluation of a potential asset i.e. an individual company. It involves looking directly into the company, assessing factors such as: financial statements, business strategy (competition, markets etc.) and management. It also means looking at the macroeconomic factors and analysing all the external influences which could have an impact on the business. In short, you would analyse each factor individually to get an understanding of the risks associated with the business.
Fundamental analysis is useful for managing risk as it enables investors get a good understanding of the company as a whole. Evaluating all the possible factors allows you to determine an intrinsic value of an asset, which you can use to decide whether an asset it over- or under-valued. Also, fundamental analysis helps you to make a projection of future performance to determine if an investment will be successful over the long term.
World-renowned investor Warren Buffett swears by looking into the fundamentals of a company. He argues:
“Risk only exists when you don’t know what you are doing.”
Ultimately fundamental analysis aims to reduce risk by understanding the business so well that the investor is confident it is a solid investment. It takes both a qualitative and quantitative view, to create a full picture of the business, thus enabling investors to understand all the possible risk factors and make an informed decision of whether to invest or not.
Fundamental analysis comes down to doing your own due diligence to ensure you make the right choices. It is important to note that fundamental analysis is challenging, requires a lot of knowledge and research, and doesn’t come with any guarantee that risk will be reduced. However, when used effectively, it is an important risk management tool which can be applied to the basis of any investing strategy. The best investors use fundamental analysis to generate the highest returns.
Diversification is the process of spreading your money across a particular asset class in order to reduce risk of the overall investment. In basic terms, you invest money into a number of different areas within that asset type, in which diversification distributes risk between each individual asset.
Diversification is possible within any asset type. It is a useful tool for managing any amount of risk you wish to take on as you invest. In particular, diversification is suitable for those who seek to invest in higher risk assets but want a greater safety from potential risk. You may find diversification most commonly within investment funds, which allow you to invest in a variety of different stocks all in one place.
It is possible to associate diversification with the proverbial saying of ‘Don’t put all your eggs in one basket’. Through diversification, the investor will own an assortment of assets, in which their portfolio is largely unaffected if one asset fails. This is because diversification reduces the risk that is associated with individual assets. Whilst one asset may be subject to a certain risk, the others won’t be exposed to that risk and so the portfolio as a whole will be unaffected by that specific risk. It means a portfolio with a number of assets basically eliminates individual risks, as they are diversified away.
A simplified example of diversification:
Portfolio A is reliant on one asset. If it fails, the investor will lose money. On the other hand, Portfolio B is reliant on 5 assets. If one fails, the investor will still own 4 other assets and the portfolio will be generally unaffected. Each asset in portfolio B will be exposed to differing risks, so the performance of each asset should be uncorrelated with one another. As risk is spread across each asset in Portfolio B, there is less risk attached overall. In realistic situations, portfolios typically spread risk across a much larger number of assets to reduce risk further.
On the whole, diversification spreads risk, thus helping investors to create a balanced portfolio which is robust. Whilst it can’t fully eliminate risk as assets of the same type will still all be at similar risks, diversification reduces the effect of specific risk to individual assets. Diversification is extremely valuable as it can offset the chance of losses and allows investors to achieve solid and consistent returns.
Asset allocation is a strategy which spreads risk across a number of different asset classes. It is similar to diversification. However, rather than investing in just one asset class, an investment is distributed across multiple types of assets. When using asset allocation, an investor may hold a variety of types of assets such as:
- Stocks and shares
- Currencies/Foreign exchange
- Commodities (Gold, silver etc.)
Asset allocation reduces the risk each asset class has on the whole portfolio. Instead of one asset class being subject to similar risks (as in diversification), each type of asset is exposed to risks specific to them. For example, stocks and shares won’t share the same risk as bonds. Investing in multiple types of assets means risks which are specific to a particular asset class can be somewhat mitigated.
Risks are less likely to correlate. As a result, your portfolio would be protected in certain downtime. This is due to the fact that there is less reliance on one type of asset. On top of that, other investments may still provide suitable returns even if other asset types aren’t doing as well. Using asset allocation is useful for creating a balanced portfolio which is right for you. It allows you a greater level of control over the risk you take on.
On the whole, asset allocation offers a further level of depth than diversification to managing and ultimately reducing the effect risk has on your investments. Being able to build a portfolio which has a greater resistance to risk can leave you feeling a lot more comfortable when investing. Over the long term it can provide you with a solid balance between risk and the returns you receive.
Managing risk in your investments
Managing risk can depend on the type of investor you are and the investments you wish to choose. You should consider and understand your own risk profile (Here) before you determine the right investments for you. There are ways to manage risk no matter the amount you wish to take on.
In determining the right investments for you, you can begin to consider how you will manage that risk. It is important you are not only able to choose investments to match risk you are comfortable with; you must also be able to manage it. Without that risk management, you could be on track to failure.
For example: You might wish to invest in stocks and shares and therefore consider fundamental analysis to manage risk. However, you may not be comfortable with researching a company thoroughly. Therefore, you should possibly consider diversification to allow you to invest appropriately. Alternatively, you may find asset allocation doesn’t provide enough risk, so could diversify within a specific asset instead.
Ultimately choosing your investments and the way you will manage them go hand in hand. You will need risk management to succeed. Whichever type of investment you choose, you must be willing to manage the risk you take on. Otherwise, you may end up with returns which are unsatisfactory.
Investment risk management is all about finding ways to optimise risk, in order to find the right balance between risk and return. By managing that risk, you can achieve returns which are optimal to you, allowing you to achieve your investment goals.