While most investors think of the potential returns possible, they do so at the danger of overlooking the flip side to the equation: Risk. All investments have risks. It may be the risk of a bond losing value over time due to inflation. It may be the risk of owning a company that goes bankrupt.
Risks can vary, and knowing how to manage those risks is critical.
While financial analysts think they can plug some numbers into Excel and know a company’s expected risk—usually by referring to an asset’s volatility, or “beta” in Wall Street lingo, risk is a more nebulous concept than what can be captured by numbers alone.
An investment that has low volatility only has that when looking at past data. Many companies with slow movements during a bull market may get swept up in the fear of a bear market—as was the case with slow-moving companies in bland, boring businesses in 2007 and 2008. There’s a reason why an investment prospectus will often state (in the smallest font possible) that past returns are no expectation of future returns—yet many investors think they are.
Most investors starting out have a bigger risk, however. They tend to misread position sizes in their portfolio. While buying what’s called a “round lot” of 100 shares may make some sense, with many higher-priced shares of companies, it may end up creating a lopsided portfolio that’s a poor fit for the market’s natural gyrations. Worse, it may mean putting more money into a poorer-performing position while smaller portfolio holdings have better percentage returns.
Risk management is at the core of investing. There are many ways to look at it, but understanding how a position may perform during an extreme event, no matter how unlikely it seems, and keeping portfolio positions reasonable, can do much to take some of the biggest investment risks off the table.
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