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While Dreaming of Rewards is Nice,
Managing Risks
Is the Key to Investing

By a Guest Writer

managing risk

At this point in time, the future direction of every market, whether stocks, commodities or currencies, is uncertain. Debt and deficit issues plague Western economies, and the growth engines in Asia and other emerging markets may finally be getting a dose of reality in the form of lower than expected rates of growth. Investment advisors the world over are advising clients to be cautious and wait for the current market situation to pass before committing their existing cash to any long-term investment strategies.

Caution may be the present watchword, but a “wait-and-see” approach is just another form of risk management, the key to reaping rewards in any financial medium where gains are available if a disciplined approach is employed to find them. If investing is all about managing risks, then, perhaps, the timing is right to review your personal risk management process by revisiting the five key steps that follow:

1) Know Thy Self: The place to start is with the firm of “Me, Myself, and I”. What kind of investor are you? What is your appetite for risk? If your investments cause you to lose sleep at night, then it is time to adjust the risk parameters of your personal portfolio. Seek guidance from a professional and study up on the subject to get the most value from outside counsel;

2) Understand the Forms of Risk: Risk comes in many “flavors” – here are the major categories:

a. Market Risk: You may have the best stock in the world, but if the market is in a downspin, it may bring your stock’s value down, no matter how good it is. Market risk describes the present concern amongst the investment community;

b. Interest Rate Risk: If interest rates go up, then bond values go down. If you own a stock in a company that is heavily leveraged with debt, then a rise in rates may reduce profitability and, consequently, the stock’s value;

c. Inflation Risk: Returns on investments must keep pace with inflation so that the “net” gain is positive, or you will be losing ground related to the purchasing power of your money;

d. Credit Risk: Does the entity supporting your stock or bond have a strong balance sheet, or is there some question as to their ability to pay obligations in the future? Similar types of risk apply to foreign investments where currency and political forces can change the risk profile overnight.

3) Respect the Risk Pyramid: All investments involve risks of various types, but the level of risk exposure on a general basis varies by type of investment. The following diagram depicts this range that should be second nature. At the bottom are the lower risk items, while at the top, these investments require special training and experience before any consideration should be given. Currency trading is included in this high-risk area, as is options trading. Each of these two investing mediums can offer significant returns with leverage, but you can easily lose all of your money if you are not careful.



pyramid



4) Learn to Diversify: Different investments and sectors of the market respond in differing ways to changing market conditions. The simple mantra of “Never putting all your eggs in one basket” is the guidance to spreading your risks through diversification. Professional advice is good here;

5) Select and Review Assets: Lastly, you must select assets for your portfolio that match your risk tolerance and return objectives. For small investors, exchange-traded funds and mutual funds offer wonderful diversification benefits by type and sector when constructing a portfolio.



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