What is risk management in investing?
Every investment carries some level of risk. According to the Securities and Exchange Commission (SEC), financial risk “refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.”
To help you better understand risk, here's an example. Let's say you think Company X is fantastic and sells a great product. You reviewed its financial records and think the stock will go up. If you buy it, there is a good chance the price will go up. However, it could also go down in value due to poor performance or a market downturn.
The possibility that the investment will go down in value is the investment's risk. Some assets carry very little risk, while others are considered extremely risky. As a general rule, lower-risk investments offer lower potential returns. The riskiest investments generally come with the best chances of earning a lot but also a bigger chance of losing money.
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Why are some assets riskier than others?
Some assets are naturally riskier than others. There are many reasons why one investment carries more risk than another. The investment could be a completely different type of asset or even within the same asset class.
- For example, AAA-rated bonds are very low risk. When you buy one, you know with almost full certainty what you will earn from the bond if you hold it to maturity. This is because an agency has researched the bonds and determined that the chances of a default are incredibly low. It's unlikely that you will lose money if you invest in an AAA-rated bond.
- Commodities like oil, soybeans, and gold are much more volatile and could have their price change in an instant for many reasons, such as market sentiment or an unexpected weather event. That is an example of a higher-risk asset.
- Even within an asset class, risk can vary. For example, a safe and stable blue-chip stock like Walmart or Ford is generally a safer investment than an unknown penny stock.
Diversification lowers investment risk. An exchange-traded fund (ETF) that tracks the prices of 500 stocks holds less risk than buying a single stock. When you own one stock, the performance of one company can make or break your investment. If the company fails or has a bad quarter, you could lose all of your money. But with an ETF, a bad year at one company will have a lot less impact on your portfolio overall. We recommend buying ETFs using Public.com, our preferred broker for ETFs.
The typical investment risk of different assets
The risk of each type of investment is different. Here's a look at investment risk from the least risky to what is often considered the riskiest assets:
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— Cash and cash equivalents
Cash and equivalents to cash are generally considered the safest way to keep your money. Savings accounts, bank CDs, and money market savings accounts offer a modest interest rate and generally come with FDIC insurance. Money market funds (different from money market savings accounts) and U.S. Treasury bills are often considered to be cash equivalents that carry extremely low risk.
— Bonds and fixed-income assets
Government and corporate bonds are a type of fixed-income investment. These assets offer a fixed, predictable income until they mature. Bonds are generally considered lower risk. However, it's wise to note that within the world of bonds, there are different risk levels. Ratings by agencies like Moody's or Standard & Poor's help you weed out “investment grade” bonds (usually any bond rated between AAA and BBB) from “junk” bonds (any bond rated BB or lower).
— ETFs and mutual funds
ETFs and mutual funds are diverse investment vehicles. With either of these types of funds, you can buy a diverse set of stocks, bonds, or other assets with one investment purchase. Note that the fund's assets may be risky on their own, so there are definitely less-risky and more-risky funds within this asset class.
— Individual stocks
Stocks may be the best-known type of investment. Shares of stock give you a small slice of ownership in a company. The price goes up and down with company performance and may also follow the overall market performance. Single stocks are considered risky by some investors but not others. This is because of the perceived volatility of single stocks. It's important to understand that, like other assets, some stocks are riskier than others.
Options are a type of derivative. (A derivative is a type of asset that gets its value from another asset.) Options generally give you the right (but not the obligation) to buy or sell a specific asset at a specific price before a specific future date. Expert investors use options to lower risk in their portfolios. However, options trading is generally a risky way to invest.
— Penny stocks
Did you read this and think, “Wait, we already talked about stocks”? Well, you're right. But penny stocks deserve their own mention when it comes to risk. Investing in penny stocks is riskier than investing in higher-priced stocks for several reasons. They are generally more volatile and less liquid and are susceptible to price manipulation from bad actors in the investment world. Many investors consider penny stocks to be more of a gamble than an investment, and they have an excellent point.
Futures are a type of investment that works similarly to options but with an important difference. Options give you a choice to buy or sell an asset on a future date. Futures require the owner to exercise the contract on the maturity date. For example, futures are popular with airlines that know they will need fuel in the future. For individual investors, however, these contracts carry a lot of risks.
Foreign exchange is the buying and selling of foreign currencies. Currencies are very volatile and trade around the clock. Relative currency prices can take big swings based on government actions, economic reports, and other less-predictable situations. That makes them among the riskier assets to buy and sell.
This is not an exhaustive list but covers the majority of investments most people will come across.
Understand and assess your investment fisk tolerance
A couple of times above, you likely noticed that some investors think some investments are risky while others don't. Who is right and who is wrong? They are both right!
Every investor must decide for themselves whether or not a specific investment or strategy makes sense for their needs. Risk tolerance is a subjective measure of what you think is too risky or not.
Risk tolerance is a very personal aspect of investing that's hard to measure with a specific number. In general, most people can take on higher risks for long-term goals and should avoid risk for short-term goals.
That could mean you are okay with a portfolio of riskier funds for your retirement investments but a lower risk tolerance for your kids' college savings or a home down payment fund.
If you are brand new to investing, working with a professional financial advisor may help you get started with a portfolio that aligns with your risk tolerance. Paladin Registry is a great service that matches you up with financial advisors. You can also choose an automated robo advisor that selects investments for you based on your answers to a survey when you sign up.
Common risk indicators and metrics
While risk tolerance can't be measured in specific numbers, you can quantify investment risk using a handful of different metrics. Here are the most common measures of risk you are likely to come across as an investor:
- Beta: Beta explains a stock's investment risk compared to the market as a whole. A stock with a beta of 1.0 moves with the markets. A higher beta indicates higher risk and volatility. And a beta below 1.0 indicates less risk and volatility compared to the overall market.
- Standard deviation: Standard deviation measures volatility and is used to infer risk. A higher standard deviation means a stock is more volatile and likely riskier. A lower standard deviation means the stock's price tends to fluctuate less.
- Sharpe ratio: The Sharpe Ratio is a bit more complex. This ratio measures the risk-adjusted return of an asset compared to a risk-free asset. That means the Sharpe Ratio can tell you how risky an investment is compared to an ultra-low-risk investment like a Treasury bill. It is often used to compare the risk level of two funds or two portfolios.
- R-squared: R-squared, sometimes called the “coefficient of determination,” is another complex statistical measure. This statistic tells you how much of an asset's movement is explained by a related index. This is similar to beta in some aspects. Putting the two together gives you a good picture of how a stock's or fund's volatility is due to the overall market and underlying index.
Manage your investment risk
Risk is a part of investing, but it shouldn't paralyze you or keep you out of the markets. Instead of avoiding risk, it's important to understand the risk you take on and whether or not it makes sense with your current investment goals.
In some cases, it could be a good idea to get out of risky assets and move toward ones with a more predictable future. But too little risk comes at the cost of returns. If you are too conservative, you could miss out on big opportunities for investment gains.
With your newfound knowledge of investment risk, you may want to tweak your portfolio to better align with your goals. But you may find your investments are set up exactly how they should be. When it comes to investment risk, following your gut instincts is often the best path forward.
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