Overview – Calculated Investment Risks May Sometimes Be Necessary
Have you ever needed to take a risk that, although you weren’t exactly comfortable taking it, you understood that it was still tolerable compared to the alternatives and that the potential reward was worth it?
Although many risks can and should be reduced to a more acceptable level, there are times when certain risks can’t be eliminated or reduced any further, and our only option is to bite the bullet.
Imagine it’s snowing very heavily right now, and more snowfall is expected over the coming days. Problem is, you’re about to run out of food, and the nearest grocery store is a 30-minute drive away.
Do you brave the heavy snow before the roads become undriveable, or do you wait until it stops snowing, hoping that roads become safe again within a few days? Both options present their own risks, but it’s up to you to decide which one is the most tolerable.
These sorts of decisions are never easy to make, and unfortunately, investors will sometimes need to make these types of decisions too. Calculated investment risks may sometimes need to be taken in order to advance certain investment goals.
When Dealing With Investment Risk, Reduce Then Regulate Them
Before continuing our discussion of taking calculated investment risks, it’s important to remember how to approach risk in the first place.
Just because you come across investment risk doesn’t mean you’re forced to simply live with it – there are steps you can, and should, take to bring it under control and to keep it low.
When dealing with any sort of investment risk, your first priority should be to eliminate as much of it as possible. This idea of eliminating as much unnecessary risk as you can is a key element of making your portfolio inherently safe, thereby reducing the need for active risk management protocols. The less risk you need to keep an eye on, the better.
Once investment risk has been reduced as much as it practically can, then risk management protocols are put in place to keep it at a tolerable level.
The notion that successful investors take on lots of investment risk in order to make lots of money (i.e., “high risk, high reward”) is untrue – successful investors know how to take on the least amount of risk needed to achieve their goals while also making sure those risks don’t spiral out of control.
Risk can never fully be eliminated because doing so would require infinite money and resources, two things no investor has. Because of this, there will always be some level of residual risk to keep an eye on. If left unchecked, this residual risk can easily become a big headache once again.
Investors take on risks all the time, but a successful investor is able to keep them under control through proper risk reduction and management. However, not every risk can be reduced to a low enough level, yet may provide benefits that can help them reach certain investment goals.
Sometimes, an investor may need to pursue risks with an elevated chance of materializing, that is, sometimes calculated investment risks may need to be made.
Calculated vs Reckless Investment Risks
It’s important to emphasize that just because an investor will sometimes need to take certain risks doesn’t mean all of them are made equal. Investors still have the power to decide which risks they want to pursue.
There is a clear difference between calculated investment risks and ones that are blatantly reckless. Let’s go over the differences.
Calculated Investment Risks
Remember, when faced with any sort of investment risk the first priority should always be to eliminate as much of it as you possibly can, then manage whatever residual risk is left. However, you may someday come across a risk that cannot be brought down to an acceptable level, but the reward it offers is very enticing.
Calculated investment risks are ones that, after careful analysis and comparison, are worth pursuing despite the apparent consequences.
They can also be thought of as a “lesser evil” – taking on a risk that can’t be reduced isn’t an easy decision to make, but when compared to the alternative risks that you can also pursue, the calculated risk is the one that makes the most sense to pursue.
There’s always the possibility of a risk materializing, but the consequences of a calculated investment risk should still be tolerable and shouldn’t leave any lasting damage on your portfolio. The consequences may be heavier than usual, but the potential reward is still worth it.
An example is using margin (i.e., borrowed funds) for investment purposes.
In the hands of a skilled investor, margin trading has the potential to supercharge potential returns. However, if things go wrong, not only will an investor be left with steep losses, but are also on the hook for repayment of the money they borrowed.
Say that an investor wishes to use margin to get a short-term boost to their portfolio before planning to sell.
They’re aware of the risks associated with margin trading, and have taken the appropriate steps needed to mitigate them as much as possible such as imposing a strict limit on how much margin they’ll use, having a thorough understanding of the investments they wish to pursue, and have enough funds on hand to repay the loan if their investments do go sour.
Using borrowed money for investment purposes can go very bad, very fast, but this investor feels that the benefits they stand to gain are worth it, and have done as much as they could to keep the risks at bay. As a result, this is a very prudent risk to take.
Reckless Investment Risks
When looking at any sort of investment risk, it’s easy to fixate on the potential reward, but at the same time, it’s just as easy to forget about the potential consequences. An enticing reward is worthless if the consequences far outweigh them.
Reckless investment risks are ones that investors pursue while fixating primarily on the reward, but fail to consider the consequences and to assess whether they can afford to take the hit if those consequences were to materialize.
What’s the point of pursuing a risk if the consequences outweigh whatever benefits you stand to gain? After all, the whole point of taking a higher-than-average investment risk in the first place is that you understand that the risk, though elevated, is still worth pursuing because your analysis has revealed that the benefit is worthwhile.
In our previous discussion, we brought up margin trading, and how it presents an elevated risk should things go bad. Assuming an investor takes the appropriate steps, then using margin for investment purposes can prove to be a wise, calculated risk.
However, if an investor is focused too much on the possibility of potentially higher returns while failing to take any measures needed to mitigate the risks that come with margin trading, the only thing they accomplish is setting themselves up for potential disaster.
Anything that presents an elevated investment risk can either be calculated or reckless. What separates them is how an investor decides to approach the risk.
Knowing When to Take Calculated Investment Risks
So, we now know what calculated investment risks are, but the big question is: when should investors seriously consider the possibility of pursuing them?
One of the oldest, yet most fundamental, concepts in investing is the relationship between risk and reward.
Investors are constantly weighing how much risk they want to take in exchange for a potential financial reward. In investing, you can’t expect to gain something for nothing, that is, you can’t expect to earn money without taking on some sort of cost, which in this case is the risk of losing your initial capital.
As was mentioned earlier, although investment risk can be reduced and managed, it can never completely go away. There will always be a non-zero chance that an investor will lose their money on a certain investment operation, no matter how safe it may appear to be.
Therefore, calculated investment risks are only worth taking on if an investor is confident that they’ll get a worthwhile reward for deciding to stick their neck out. No sensible investor would put their money and/or resources on the line if they stood to gain very little.
This is why it’s so important to stop and ask “Will this really be worth the time, stress, and potential hassle?” If there is no satisfactory answer to this, then perhaps the risk isn’t worth pursuing.
While pursuing calculated investment risks may sometimes be an option, it’s important to review all your options first before even considering the possibility of pursuing a risk you can’t hope to control.
Calculated Investment Risks Should Always Be the Final Option
Although investors may sometimes need to take calculated investment risks, this doesn’t mean they should be the first option to cross their minds. Calculated investment risks should always be treated as the final option to pursue if every other option proves to be inadequate.
Remember, an investor’s first priority when faced with any sort of investment risk is to eliminate as much of it as they possibly can, and then establish proper risk management protocols and practices to keep it low.
No sensible investor takes on more investment risk than they absolutely need to. Although calculated investment risks are carefully analyzed before being pursued, they’re still an additional headache that has the potential to deal damage to an investor’s portfolio, so it makes sense for them to be pursued only when no other options are left.
Unless you are forced to pursue a certain investment risk, it would be wise to take a step back and assess all the options available to you before even thinking of taking on additional investment risk.
Wrapping Up
In order to make money from investing, investors will need to shoulder risk. However, this doesn’t mean investors are forced to take on prodigious amounts of risk if they want to grow their portfolios.
Successful investors understand that they can reduce risk and keep it at bay while simultaneously growing their portfolios. When faced with any sort of investment risk, the first action to take should be to eliminate as much of it as possible, and then establish risk management protocols to keep it low.
Sometimes, however, investors may come across risks that are higher than usual but may still help them achieve certain investment goals. Sometimes, investors may need to take calculated investment risks.
Although calculated investment risks may occasionally need to be taken, they should only be pursued after very careful consideration, and after making sure every other option has been exhausted. When dealing with investment risk, the last thing an investor wants is to take on more than they absolutely need to.
