I’ve been an entrepreneur for more than 20 years now, the latter half of which I’ve been playing the dual role of an investor as well. It’s an interesting gig as transitioning from entrepreneurship to investing is an entirely different ball game. However, in both cases there’s a common factor:
risk.
Both entrepreneurs and investors are people who are known as risk-takers with varying levels. As an investor, you are someone who’s calculated in your investment risk vs return approach, dangling capital you can afford to lose but obviously don’t want to as you chase a potential payoff. Finance is hard and very, very expensive if you’re not disciplined and knowledgeable about its ins and outs. There’s no room for trial and error.
In that spirit, here are some ways you can avoid and/or mitigate investment risk in your business ventures, starting with:
Know investment risk types
Being an investor means being exposed to different types of risk so, in order to successfully minimize them or avoid them altogether, you first have to know what to expect and the level of impact each type has. There are more than a few classifications of investment risk types as the very definition of ‘risk’ is general and slightly vague. Some of the more important ones are:
- Market risk – also known as systematic risk, this is an umbrella term for any type of risk where the value of an investment declines due to certain political and economic developments or other market-affecting events. Market risk includes a subset of specific risks such as equity risk, interest rate risk, and currency risk.
- Business risk – relates to the basic viability of a business and its vulnerability to numerous factors such as competition, customer preferences, level of demand, and other metrics that might lower profit margins and chances for the company’s success. Basically, it’s about whether a company will be able to generate enough sales and revenue to cover its operational expenses and turn a profit. Business risk includes several other specific, business-related risks such as strategic, operational, reputational, and compliance.
- Volatility risk – refers to the risk to the value of an investment due to unpredictable changes in the volatility (price swings) of the underlying asset such as a stock. Volatility risk is directly tied to the width of the trading range between the high and low price levels at which a stock or commodity has traded.
- Specific risk – a risk that is not correlated with market returns but is specific to a certain company or industry. It is affected by internal and external elements like the operational efficiency of the business, the capital structure of a company, or new industry regulation and even shift in user behavior.
Understanding these types allows you both to manage risk and optimize the outcomes of your investments. For a more detailed breakdown of risk in investing, including types and examples, give this a read.
Identify your risk tolerance
Every investment inherently comes with a certain level of risk but it’s your investment risk tolerance that quantifies how much risk there actually is for you. Risk tolerance is different for everyone but generally speaking, it refers to an investor’s ability to withstand the potential loss of money on an investment. It’s an indicator of how much loss you’re willing to accept if/when your investment(s) perform(s) below standard.
Risk tolerance is extremely important to figure out as not everyone can cope psychologically with the idea of losing money. As such, it largely determines what type of investments you will or won’t make. Knowing your investment risk levels helps create a plan on which you can build your investing acumen – if you’ll be aggressive, play it safe, or be somewhere in between. To do so, you need to understand that the risk tolerance fluctuates based on key investment risk factors:
- Objectives – depending on what you want to achieve (e.g. retirement, saving for your kids’ higher education, or buying a house), a higher reward requires a higher risk.
- Time – risk tolerance changes over time along with your financial standing. Typically, younger investors are riskier because they have the benefit of time to recoup potential losses while those that are close to retirement exhibit a lower risk tolerance and place focus on more stable investments.
- Net worth – naturally, investors with a higher net worth have more cushion to go for riskier investments than those who are strapped for money.
- Experience – if you’re just starting out, it may be wise to take it slow and exercise caution before you go big. It’s important to be able to envision the worst-case scenario by soaking up knowledge so you know you’ll be able to take the risk.
- Emotions – judgment can be easily clouded if your personal comfort level is exceeded. Some are more comfortable with risk-taking than others who can become overly anxious, for instance, when it comes to the potential of losing money – even if there’s enough time for the investment to recover.
Knowing your risk tolerance is a complex process that only you can find an answer for by evaluating your financial situation and balancing it against your objectives. Sticking to investments that fit the mold will not only let you sleep soundly at night but more importantly – prevent you from the financial abyss.
Choose an investment risk management plan that suits you
While some risks are largely beyond your control, others can be directly managed. This makes investment risk management a hack to dependable and steady profits in any market conditions. Think of it as playing great defense when it comes to the game of investing – without one, you are one bad or misguided investment away from the financial ruin. You don’t want to have the offense constantly make up for losses when executing plays. If you’re busy plugging the hole, how are you ever going to make money?
I’ll focus on three strategies you can use to reduce the odds of said financial destruction to as close to zero as possible:
- Diversification – one of the most popular principles in investing, diversification is the epitome of the proverb ‘don’t put all your eggs in one basket’. The idea is to invest in a variety of assets and industries such as equity, bonds, real estate, cash, and such that are not correlated, meaning that if one goes down, you’re not too exposed. A fall in value in one investment won’t affect your other investments you can fall back on, making diversification a good strategy to limit risk. Make sure you do your research and focus more on recent performance than historical data that may be just that – history.
- Asset allocation – by having different asset classes (grouping of investments that show similar traits and are subject to the same laws and regulations) in your portfolio, you increase the likelihood that some investments will result in satisfactory returns despite others losing value. Asset allocation can also be looked at from another point of view – as means to minimize the risk of major losses that can come from placing too much emphasis on a single asset class, however resilient you might expect that class to be.
Asset allocation and diversification are often used interchangeably but the key difference is that the former is used to distribute between asset classes in an investment portfolio, while the latter refers to the allocation of capital within those asset classes. - Investing consistently aka. dollar-cost averaging – the idea here is to invest certain amounts on a regular basis regardless of what the market is doing. That means that sometimes you’ll buy high and other times you’ll buy low to maintain the initial cost/average price of the investment and with markets typically rising over time, you’ll likely do well over the long term. The key is to carefully pick companies to invest in. Investing consistently is best for buying stock in companies and industries you expect to register sustained growth over time rather than choosing the risky startup route (except if you’re willing to take on higher risk).
If your objective is financial stability and security like with many investors, then risk management should be one of your primary focuses.
Employ the bucket strategy
I’ve always liked this idea of dividing a portfolio into different segments based on different timelines because as an investor, you’ve got plenty of control over your time. That’s a luxury (and ultimately, what makes all the difference) when you want to plan your life, whether it’s a couple of months ahead, a few years ahead, or decades.
The bucket strategy is great because it allows you to diversify your investment portfolio across various asset classes, as well as to reallocate your resources as necessary. In a way, it works as an investment risk assessment. The idea is this:
you divide your portfolio into different segments, based on your goals or spending needs. Essentially, what you do is put your money in buckets which you can access as you need to, leaving the rest in riskier investments envisioned to promote growth in a portfolio.
While there are many variations of the bucket strategy, they typically follow a similar theme of time segmentation:
- Short term bucket – money you think you’ll need within the next three to five years. Typically contains cash in the form of bank savings accounts or money market mutual funds.
- Medium term bucket – money you likely won’t need for the next five to ten years. Typically contains fixed-income assets such as bonds or bond mutual funds.
- Long term bucket – money you know you won’t need for the next eight to ten years, and even longer. Typically contains stocks.
If your plan is to rely on your portfolio for the majority of your income, then a bucket strategy is a great option. It helps protect against longevity risk and seeing as most investors have a longer retirement than usual, maintaining a piece of portfolio in growth assets is a sensible way to lower the odds of running out of money. By segmenting into distinct time frames, you are also prioritizing the times you will need money, making bucketing a way to manage investment risk.
Now, I have a personal spin on what goes in each bucket, as viewed from a more entrepreneurial angle. First of all, I have four buckets, where the first one is a company that has cash flow. Once you have that, you can always leverage because there’s no good investment if you’re only working on your own cash-on-cash return but at the same time, you don’t want to risk too much.
To hedge and invest smartly, you need to have a second bucket – stocks because of liquidity. It’s not that this is a really good investment but more of a really good way to have cash in, cash out. This is really important when you want to invest as you may have to change things or have problems with the business so you always have to have liquidity.
The third bucket has real estate as it’s actually hedging the stock market and, as such, hedging your business due to its stagnant nature. It’s not liquidated but you can always leverage it and it gives you something that’s very solid.
The fourth bucket contains commodities as everybody is going to eat, drink, and such – basic necessities. Plus, commodities also hedge your stocks.
This is a way to be rich enough but not make big money because each of those literally cancel out one another. You’re betting on the long run, which will certainly require some adjusting over time as the market swings, inflation, and lifestyle changes factor in.
The drawback to the bucket scheme is that it can be a hassle as you must frequently monitor where you are placing your money. But then again – there are far worse things than an investor keeping track of his investments, right?
Make a calculated investment risk
For a smart person, investing can be a fairly easy and less stressful way to make money. I say ‘smart’ because those who are successful at it take calculated risks. Arguably, one of the main goals of any good investor is to protect their capital. Caution is always welcome when exploring investment avenues as it keeps investment losses to a minimum. The best way to do so is to develop a strong intellectual framework for decision-making and keep your emotions in check, especially during times of market stress.
Image credits:
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