Saturday, October 28, 2006

Investing 101 - Managing Risk Successfully

“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” - Mark Twain

To successfully build wealth, one needs to understand the concept of risk and manage it well. For several detailed mathematical and psychological definitions of risk, see Wikipedia. Here are my working definitions for risk:

Individual Risk. That is the risk associated with your specific investment. An example of Individual Risk is a biotech stock declining even though most biotech stocks are rising.

Market Risk. That’s the risk that is associated with the area in which you are involved. An example of Market Risk is the current real estate “bubble.” In general, all real estate will experience the same issue, i.e. declining, when the bubble breaks. If you own real estate when a real market declines, you will likely experience a decline.

Risk Tolerance. This is describes the level of risk with which one is comfortable. When risk is below your risk tolerance, you sleep comfortably at night. When risk is above your risk tolerance, you are constantly on edge.

To be a successful investor, one must take steps to manage the risk in each of the areas. Here are approaches I’ve used to help manage risk:

Reducing individual risk can be achieved by diversifying within an asset class. For stocks, that means choosing stocks in different industries. Minimum risk can be achieved with as little as 10 stocks. For real estate, that may mean buying different types (residential, multi-family, commercial) of properties.

Reducing market risk can be achieved by investing in different assets that are negatively correlated. For example, real estate and gold tend to be negatively correlated with stocks. When stocks are rising, gold and real estate tend to be stagnant or declining. When gold and real estate are rising, stocks tend to be stagnant or declining. By diversifying across several asset classes one can minimize downside risks. However, diversification also tends to limit upside gains, for the same reason.

While the first two have statistically based solutions, increasing risk tolerance addresses an emotional challenge. One way to manage risk tolerance is to minimize the negative impact of any downside risk. A second way is to build you risk tolerance over time. A third way is to ignore it :-)

I have a low risk tolerance and am most comfortable when my investment strategies are preserving my principal. My investments tend to have low risk for loss of principal and only a small amount is invested in speculative opportunities (e.g. options and turnaround stocks).

Mitigate the negative impact of a market downturn by creating a savings foundation on which you can fall back. Only invest funds after you have paid off non-mortgage debt and created an emergency fund. Invest funds which you won’t need in the short term and can afford to have fluctuate.

Build your risk tolerance over time. I split my investments among low, medium and high risk areas. I have the majority of funds in low risk investments (e.g. CDs) and portion in higher risk investments (e.g. stocks). I know most advisors recommend a 75/25 or higher split of stocks/fixed income. I began with a 0/100 stock/fixed income split. I have moved to a 40/60 stock/fixed split over time. It’s a split with which I am comfortable, and therefore, can sleep with at night.

Understand your risks. Build your knowledge about your investment options, hire professional advisors to provide guidance, or learn from a successful experienced practitioner. With knowledge, one can make better and more successful decisions on investments and risk. My father successfully invested in stocks and real estate. He taught me many of the basics. Value Line Investment Service has a demonstrated successful stock investment methodology. I have also established a relationship with a local real estate agent. All have been helpful references with my investments in stocks and real estate.

As you master the management of risk, you will increase the probability of your investment making money.

Here are the current posts in the Investing 101 series: Part 1 - Getting Started; Part 2 – Managing Risk Successfully

This is not financial or investing advice. Please consult a professional advisor.

Copyright © 2006 Achievement Catalyst, LLC

4 comments: said...

A good intro to the need to manage risk. For some additional info on the different types of risk, how it is estimated using standard deviation, etc. see my recent post (Oct 19) "The types of Investment Risk". For those interested, I also have some detailed posts about the use of gearing, and how this affects risk and return.


Super Saver said...

Enough Wealth,

Thank you for your comment and the references to your blog. Your post provides a comprehensive list of the types of risk and a good mathematical explanation using standard deviations.

Thanks also for introducing me to a new term "gearing." Based on what I read, gearing appears to be the equivalent of using margin. While I understand the risk and benefits of using margin, I have chosen not to use it in my investing strategy. For me, since margin is a form of debt (although, hopefully, short term debt), I choose not to use margin for my stock investments.

Good luck in your personal finance journey. Your blog indicates you have made excellent progress towards your goal.

Manny said...

Great post.
It is startling how often investors only focus on upside potential, when there are so many diferent types of possibilities that might damage one's capital. Thomas Schweich's book "Crashproof Your Life" is a classic in this regard. I review it here:

Manny said...

Great post. Risks to one's capital come in all shapes and sizes. Thomas Schweich has done a lot of deep thinking on this matter in his book "Crashproof Your Life". I review it here: