Different Types of Investment Risk
I assume no one wants to take on investment risk and the word is so often used to describe the stock market that even a kid (when I was 15) believed that the market was “risky.” But what is risk and how do we reduce it?
Dictionary Definition of Risk
By definition, risk is officially
“the hazard or chance of loss”
No arguing about that definition because you could easily lose your pants in the market. However, the above definition doesn’t provide anything in perspective. It is just a generic meaning that people spurt out in any situation, and especially in regards to stocks.
Investment Risk in Context
If we go with the above definition, driving, cycling, walking or basically breathing the smog outside our homes is risky. Yet not many people overly worry about being in a car accident, tripping and breaking their leg or getting lung cancer from smoking. Why?
Because we understand that if we do things a certain way, we can be close to risk free.
Being an alert, defensive driver will help you avoid many accidents. Looking in the direction you are walking will prevent you from hitting the pole in front of you (I learned this the hard way), and smokers understand what they are doing from the very beginning.
Let me go through some different types of investment risk and the order in which I would rank them.
1. Financial Risk
The basic rule of thumb is that you
- should not consider the market like a savings account
- should not invest money which you will need to use in less than one year
Markets go up and down. There is no guaranteed return for just depositing your money into a fund or stock and since we can’t predict the markets, if you have something urgent coming up, like a wedding, keep it in something liquid and stable.
I also find it surprising that many investors, usually single young males, do not have their finances in order before investing. There are people who have fairly high mortgages or rent, car, utility payments etc yet use up a big chunk of their paychecks for the market and then claim they are living paycheck to paycheck and finding it hard to make ends meet.
Investing with this mentality will only increase your risk.
2. Over-Confidence Risk
One of the major killers to any investor or person in general. I also call this “I know what I’m doing” risk. When times are good and the market is rising anyone can make money. We may take this as a sign that our investing strategy and acumen has greatly improved and signs of what is to come.
When good things happen, our heads usually get bigger, and it’s when our heads get to heavy for our necks to support, something goes wrong.
Think of 3 people that you know personally that invest. I am going to ask you a simple question.
Are you a better investor than them?
Most people would have answered yes but maybe our better halves are actually better..?
3. Asset Management Risk
So you already have your financials in order and know yourself pretty well but without proper asset management, you could be exposing yourself to additional risk.
A good poker player always makes bets or calls a bluff in conjunction to the pot size. They strictly maintain their money management and bet accordingly depending on the odds.
This is no different with our own portfolios. Do you track your portfolio in detail other than the stock price and how much gain you have?
4. Business Risk
This risk is familiar and easy to reduce. First of all, this has everything to do with whether you understand or not.
A business is considered risky due to many factors.
- Erratic cash flows
- Majority of revenues coming from one product – refer to AeroGrow, GeoEye
- Lack of management experience
- Financial insolvency
- and so on
If you understand the company and how it all stacks up, your perception of the risk will obviously differ to someone who doesn’t understand it as well.
Like I mentioned before, a smoker perfectly understands the risk involved with smoking and has a different view than the non smoker who sees far greater risk.
5. Valuation Risk
Another obvious risk. Don’t overpay, or if you decide to, don’t overpay by a ridiculous amount.
The tech bubble and the financial crisis all resulted because people believed prices couldn’t go down and basically thought a site like my blog was worth $1M and going up everyday.
When I go through companies and I don’t know what it’s worth, it ends up in the pass pile.
As Buffett has said regularly, risk comes from not knowing or understanding.
“With All Thy Getting Get Understanding” – Proverbs 4:7