Reach Your Investment Goals by Minimizing Risks
In any endeavor, there’s always some form of risk. If you’re going on a trip, there’s a risk you won’t reach your destination. If you’re applying for a job, there’s a risk you won’t get accepted.
In the context of investing, risk is defined as a “deviation from an expected outcome.” The goal of any investment is to realize a profit, the risk to investors is that there’s a probability that they won’t see any profit from their investment. Worst-case scenario, the investors stand to lose all of the money they invested.
Because of the differences in the way people think, people may perceive risks differently. Some may exhibit loss-aversion so they have a negative view of investments because they put more value on avoiding losses than on the feeling of having gained something.
Good investors understand that they have to take a risk in order to realize a profit. Great investors know how to manage risks in order to make sure that they reach their investment goals.
There are several types of risks that stock or bond investors face. These are:
Credit or Default risk – the possibility that the company or individuals won’t be able to pay the interest or principal of the debt. Companies can go bankrupt so they may have problems paying investors who hold their bonds. Banks who lend money to individuals also face credit risks with their customers. Banks loan money in order to realize a profit in the form of interest payments and they face the risk that the person they lend money to won’t pay them back.
Country Risk - refers to the possibility that a country will not be able to honor its financial obligations. The global economic crisis affected the economies of many countries including the U.S. as well as European countries like Portugal, Ireland, Greece, and Spain. The situation in Greece was so bad at one point that Greek government debt was downgraded to junk bond.
Market Risk – refers to the day-to-day fluctuation of a stock’s price. This is also called volatility and is an effect of market forces.
Foreign-Exchange Risk – Companies that operate in several countries are especially prone to this risk. A U.S. company’s Malaysian subsidiary may earn a profit for the year but the parent company could still be in the red if the Malaysian ringgit depreciates against the U.S. dollar.
Interest Rate Risk – this affects bonds more than it affects stocks. The investment’s value may due to interest rate changes.
Political Risk - Governments may suddenly change policies. An investor who wants to export to one country may find himself suddenly unable to go ahead with his plans if the foreign government bans imports from the investor’s home country.
As an investor, you need to set your tolerance for risk. Try to consider less risky investments but low-return investments, like government bonds, and weigh them against higher-risk investments that have a higher potential for returns like stocks.
If you’re a risk-averse investor, then putting all of your investments in government bonds would satisfy your risk appetite. If you’re looking for high returns and have a stronger stomach for risk, then you could put all of your money in more rewarding investments like stocks.
Diversify Your Portfolio
To minimize risk but still position your investment so that it earns more, you need to diversify your portfolio. There will never be a totally risk-free investment but diversification keeps your risk to a minimum.
Diversifying your portfolio means investing in different investment vehicles. These include stocks, bonds, real estate, mutual funds, exchange traded funds, and businesses. To further diversify your investments, you should own different investments that have varying risk profiles.
You can buy low-risk blue chip stocks together with stocks that may be a little riskier but could reward you with higher returns. The same is true with investing in bonds. You could invest in government bonds and corporate bonds.
To minimize country risks and foreign-exchange risks, you could diversify your investments and purchase stocks or bonds from different countries or regions. You could also buy stocks from different industries to increase the diversity of your portfolio.
All investors have their own measure of risk tolerance and investment goals. Great investors know that risks are inherent in every type of investment and that they need to take steps to minimize these risks and avoid losing all of their investment. Portfolio diversification lets investors minimize the risks to their investments and puts them in a position to realize their investment goals.
About the Author:
This is a guest article by CompareHero.my, the leading comparison portal for credit cards, bank products and insurance in Malaysia