Last Updated on January 31, 2025
Overview – Managing Investment Risk Doesn’t Have to Be Complicated
Many investors are aware of the dangers posed by investment risk (for a refresher, we discuss investment risk here), and know the importance of keeping it at bay before it spirals out of control.
Every investor wants to keep investment risk as low as they possibly can, or even take steps to eliminate it entirely, but it’s easy to subscribe to the false belief that doing so is a time-consuming, onerous task.
Fortunately, there are many methods for investors to manage investment risk manageable without spending exorbitant amounts of time doing so. Let’s go over what some of those are.
Risk Management Can Be as Complicated or Simple as Investors Want It to Be
Although this article will cover some practical ways to reduce, or at least manage, investment risk, this will not be a comprehensive list. To understand why, it’s important that we preface with an oft-forgotten reminder: risk management can be as complicated or simple as investors want it to be.
As we’ve gone over in another article, risk management is a continuous process whereby risks are identified, analyzed, and then managed/reduced. While the theoretical understanding of risk management is relatively straightforward, knowing how to apply it in practice presents a different challenge.
Some investors opt to use very sophisticated risk management strategies such as hedging, asset allocation, geographic diversification, and automated trading, to name a few. While these methods can be effective ways to manage investment risk, this doesn’t mean risk management always has to use sophisticated tools/methods.
Managing risk isn’t just about deploying sophisticated tools. It’s also about having certain behaviours, procedures, and other “soft factors” that, although can seem relatively pedestrian, can be just as effective, if not more, at managing investment risk. If that’s the case, then there are, theoretically, countless ways these soft factors can be applied as practical risk management tools.
Ultimately, risk management isn’t a matter of who deploys the most complicated methodologies, but rather which methodologies lead to the best results. “Simple” doesn’t necessarily mean “ineffective”.
Let’s go over what some of those “simple” methods are.
Make an Investment Decision Only After Considering the Relevant Facts
This may seem like a no-brainer but is arguably one of the easiest ways to avoid having to deal with investment risk right from the start.
Knowing how to manage investment risk is an important skill, yes, but truly skilled investors know how to avoid potential sources of investment risk entirely, reducing the need for risk management in the first place. How is that possible? By considering as many relevant facts as possible before making any kind of final decision.
By making the most informed decisions possible, investors can avoid acquiring risky investments altogether, and instead acquire ones that pose significantly less risk. Half the battle of maintaining and growing an investment portfolio is making judicious decisions.
There’s no need to worry about managing investment risk if there isn’t any to manage to begin with.
For example, say you’re analyzing a tech company that specializes in selling computer hardware. You notice that, despite their strong financial and qualitative performance, their supply chain is a potential source of risk: their supplier of semiconductors has faced manufacturing challenges, struggling to produce enough semiconductors. This supply constraint could mean the tech company could, in turn, struggle to produce enough of its hardware, potentially impacting sales.
Instead of hoping this tech company can resolve its supply chain issues, you can avoid it entirely and look elsewhere, not having to worry about this potential source of investment risk to begin with.
Investors can eliminate potentially risky investments from entering their portfolios if they simply take the time to look before they leap. By making decisions only after all the relevant facts have been accounted for, they save themselves the trouble of unknowingly putting a risky investment in their portfolio.
Manage Investment Risk by Keeping Your Number of Holdings Manageable
Portfolio concentration vs. diversification has long been a widely discussed investment topic, and understandably so. Both approaches offer compelling strengths, while also presenting equally valid weaknesses.
In the context of managing investment risk, which approach is “best”? To try and find a solution, let’s explore each approach individually.
When looking at concentrated investment portfolios, one of the arguments made against them is that they’re more prone to the effects of volatility, and can experience steeper declines in value if certain, highly concentrated holdings sharply decline. However, when it comes to managing investment risk, concentrated portfolios are easier to deal with.
Why? Because fewer individual holdings need to be assessed, making it easier to gain a thorough understanding of each holding’s risk profile. Performing thorough risk management on a dozen or so holdings is much easier than performing that same job on dozens.
Although diversified portfolios offer greater variety in the sorts of investments a portfolio can have and can better protect against volatility, each additional holding represents another source of investment risk that must be thoroughly assessed. Performing this work on dozens of individual holdings will certainly prove to be challenging.
If individual holdings present a source of risk, and if each holding must be individually studied to understand its risk, then one way to manage investment risk is keep the number of holdings in your portfolio manageable.
“Manageable” in this case means having the ability to thoroughly analyze individual holdings without investors feeling the need to rush their work or feel burned out every time they do so. One investor may find 15 holdings to be their sweet spot, whereas others may have no problem dealing with more than 50.
As you may know from your own life, sometimes “less” is “more”.
Don’t Ever Make Investment Decisions Based Solely on What Everyone Else is Doing
Throughout their careers, it’s easy for investors to look around and see what everyone else is doing, and to think to themselves “Should I be doing what everyone else is doing, too?”
There are many advantages to observing and listening to other investors, namely because their actions can potentially uncover larger trends or they can divulge information that wouldn’t otherwise be obtainable elsewhere.
However, when it comes to the specific actions they take, it would be unwise to believe that just because everyone else is doing something makes it the right thing to do. Investing history is rife with examples of investors succumbing to herd mentality, only to find out when it’s too late that the prevailing mentality was fundamentally incorrect.
So many investors throughout history took on more investment risk than they could handle simply because they made their decisions based solely on what everyone else was doing, regardless of whether it was right or not.
As we mentioned earlier, half the battle of maintaining and growing an investment portfolio is making judicious decisions. That means knowing when and when not to do something.
Blindly following what the rest of the investment crowd is doing is one of the fastest ways to be exposed to prodigious amounts of investment risk. Remember, investors aren’t right because others say they are, they’re right because the facts and analysis they’ve performed prove that they are.
Wrapping Up
Most investors know the importance of keeping investment risk on a tight leash, the problem some of them face is knowing how to implement their theoretical knowledge of risk management into tangible tools, procedures, or methodologies.
While some investors choose to deploy sophisticated risk management tools/methodologies, this doesn’t mean “simpler” methods are irrelevant. “Simple” methods, if implemented correctly, can prove to be just as effective, if not more, than the sophisticated ones.
Regardless of how simple or complex an investor’s risk management approach is, the ultimate goal should always stay the same: to prevent investment risks from spiralling out of control and to minimize their effects should they ever materialize.
