Risky Business

March 24, 2022 08:23 PM By alex.locker

High valuations.  The Russian invasion of Ukraine.  Inflation.  Interest rates rising.  The supply chain. A bear market.  A bull market.  What do all of these have in common?

They all can be causes of "risk".  Risk can mean many things: uncertainty, volatility, or loss, depending on one's perspective.  I might address the various types of risk investors face in the future (such as market risk, company/industry risk, currency risk, interest rate risk, etc.).  However, there are some universal rules for how to handle risk that I thought might help when you are uncertain.  You have 5 basic options/tactics (with examples).

  1. TRANSFER THE RISK = If you own a particular investment and no longer want the risk that it has, you can transfer that risk to someone else (i.e., sell the holding and let someone else deal with it). 
  2. ASSUME THE RISK = Company X's stock dropped by 20% recently, but you believe the price is too low and buy 100 shares.  You have assumed (retained) the risk in order to pursue a potentially greater reward (or incur a potentially greater loss). 
  3. REDUCE THE RISK = Until now, your only investment has been ABC company stock (your employer).  You decide to diversify your portfolio with other stocks/bonds/funds, but keep 50% of your original ABC investment. This way, while you still may rely on ABC for your compensation - as well as your health insurance, life insurance, and some wealth creation (through stock options, for example) -  your overall portfolio volatility may decrease, just case ABC underperforms since the other investments may not respond to market conditions in the same way ABC does. 
  4. AVOID THE RISK = You are evaluating holdings in a particular industry which has declining profitability due to economic factors.  You decide not to purchase any investments in this industry for the time being.
  5. SHARE THE RISK = Think of your insurance company.  If you are involved in a car accident, potential costs from damages are shared between you and the insurance company.  The risk isn't shared equally in this case, but it is shared.

In closing, remember the words of legendary investor, Benjamin Graham:  "The essence of investment management is the management of risks, not the management of returns."

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