In finance, risk refers to the amount of uncertainty and/or potential financial loss that comes with making an investment decision. It’s this threat that drives our emotions and determines where we put our capital. It holds millions of people back from making huge returns but it also turns average investors into millionaires every day. So how do we manage and limit risk? How do we control our emotions, practice logical thinking, and not let fear get in the way? How do we leverage this uncertainty to make smart decisions? The answer lies in understanding the different kinds of risk and how to minimize their impact.
Risks Coming from the Business
When the Board of Directors of a business cannot fully assess and respond to the risks associated with their company, your money is not going to be safe. To find the best stocks that offer the greatest potential, do your homework and find out everything you need to know about the business and people you’re investing in. Some starting points for research are:
- Earnings growth
- Strength in the marketplace
- Price-to-earnings ratio
- Debt-to-equity ratio
This refers to the possibility of stocks declining in value due to economic developments that affect the market. Under this umbrella, you’ll have to think about three different categories of risk:
- Equity – the probability of receiving a return above or below the expected return.
- Interest rate – signifies the possibility that the value of a fixed-income investment will decline as a result of unpredicted fluctuations in interest rates.
- Currency – the prospect that currency devaluation will negatively affect the value of one’s assets.
How to Minimize This Uncertainty
In order to minimize uncertainty, you can implement the following routines into your portfolio:
- Asset allocation – this refers to the way you weight the investments in your portfolio. Asset allocation is often described as the number one factor that affects success rates so take some time to understand what it means and how you can implement it.
- Diversification – this is the process of choosing an assortment of investments within each asset class. Diversifying will minimize your risk and reduce the impact that swings in a particular market place could have on your overall portfolio.
- Dollar-cost averaging – refers to situations where investors apply a specific dollar amount toward the purchase of stocks, bonds and/or mutual funds. Following this method will help reduce the negative impacts that market fluctuations can have on your assets.
- Set your threshold – determining what level of risk you’re comfortable taking is important. Think about the capital you have, your age, personal circumstances (kids, marriage), and take your knowledge and experience into account too. Knowing when you’re reaching that threshold is even more important so check your portfolio regularly.
- Avoid temptation – It’s easy to follow the herd when investing as nobody wants to miss out on the next big opportunity. Nobody wants to be the last one to sell in a bearish market and nobody wants to miss out on buying stock when it’s available at such a good price. Yet, nobody wants to lose all of their funds based on the bad decisions that others make.