Overview – Some Easy Ways to Minimize Investment Risk
One of the many challenges investors regularly face is how to keep their portfolio’s investment risk as low as they possibly can.
If you haven’t already, I recommend you read the article Investment Risk – An Engineering Perspective before continuing. In that article, “investment risk” was defined as the probability that an investor will lose their money, and how much money they stand to potentially lose.
Every investor wants to keep investment risk as low as they possibly can, but it’s easy to subscribe to the false belief that doing so is a time-consuming, arduous task that isn’t worthwhile.
Fortunately, there are methods for an investor to keep investment risk manageable without spending exorbitant amounts of time doing so. I will share some of the techniques I use to accomplish that goal.
Proactive vs Reactive Risk Management
It’s important to note that not all risk management methods and practices fall under one category.
When it comes to managing investment risk, I’ve observed that most investors choose to take either a proactive or reactive approach. Perhaps you’re already familiar with what it means to be proactive vs. reactive.
In the context of managing investment risk, a proactive risk management approach is one where an investor takes actions that reduce the likelihood of investment risk from materializing in the first place. On the other hand, a reactive approach is when an investor deals with risks as they appear.
Imagine we have two real estate investors, Investor A and Investor B, and both are looking to buy the same apartment complex as a rental property. Compared to other apartment complexes of the same size and age, this one is relatively cheap.
Both investors do their research, and they both find out that the apartment complex is located in a less than desirable neighbourhood. There have been a handful of people who owned this apartment complex in the past decade, but their ownership only lasted for a few years because it was hard to attract high-quality tenants, meaning persistently high occupancy rates. The tenants who did occupy the complex were less than ideal, as most of them struggled to pay rent or, at times, couldn’t pay it at all.
Both Investors A and B currently own apartment complexes in less-than-ideal neighbourhoods of similar size and age, so they both have the same experience when it comes to managing this sort of property.
Investor A, having learned from his experience that this type of property brings a flurry of headaches and lots of investment risk, chooses not to buy this apartment. They’d rather find an apartment complex in a better neighbourhood that costs more rather than buy this cheap apartment and deal with the inevitable headaches.
Investor B, however, is convinced that this apartment complex is just a fixer-upper in disguise, and despite the investment risks that may arise, is certain that they can be kept to a tolerable level with enough time and effort.
Put another way, Investor A chose to eliminate the possibility of taking on more investment risk (proactive), whereas Investor B has chosen to deal with the risks as they appear (reactive).
While both approaches are valid, my experience has shown me that a proactive approach is much more effective than constantly putting out fires as they appear. So, the three methods I’m about to share lean more towards a proactive rather than a reactive approach.
Make an Investment Decision Only After Considering the Relevant Facts
This may seem like a no-brainer, but this is one of the easiest ways to avoid having to deal with major problems down the road.
If an investor isn’t aware of the relevant facts surrounding an investment operation, they are putting themselves in a very precarious situation because their decisions will inherently be flawed. An investment decision is only as good as the facts and data that go into forming it – if an investor is working with insufficient or flawed facts and data, then their decision is doomed to be flawed as well.
Imagine you are planning to buy the shares of a construction company. Upon performing your due diligence, you conclude that this company is worth investing in. However, you missed the detail that this company’s work is contract-based; that is, every project they take on is agreed upon via contract.
In other words, if this company fails to secure or renew construction contracts, they have no source of revenue. Contract-based projects are common amongst Engineering, Procurement, and Construction (EPC) companies.
Because you are unaware of this contract model, you skimmed over the fact that they have steadily been losing contracts over the past few years, and their financials only appear healthy because their current clients have agreed to pay more. Should those contracts with big clients fail to be secured or renewed, then this construction company faces the possibility of losing a considerable amount of revenue.
Since you missed this in your analysis, by investing in this company you unknowingly have taken on a large amount of investment risk, simply because your analysis wasn’t as thorough as you originally believed it was.
Sure, the argument can be made that an investor won’t know everything before making an investment decision, but they don’t need to.
Assuming an investor relies on annual reports, quarterly reports, news releases, and analyst reports, and the analyses of other investors, these sources provide more than enough information to work with. The onus rests on investors to go over these sources with a fine-tooth comb to find the details. Nobody is going to spoon-feed you the details.
By making decisions only after the relevant facts have been accounted for, you save yourself the trouble of unknowingly putting a risky investment in your portfolio.
Keep Your Number of Holdings Manageable
One of the oldest debates in investing is that of concentrated vs. diversified portfolios. I’ve previously explained the differences between portfolio concentration and diversification, as well as my personal stance regarding diversification.
One of the reasons I choose to go with a concentrated investment portfolio is because I hold only a handful of different holdings, I can understand all my holdings inside and out. By doing so I’m fully aware of how much investment risk each holding poses to my portfolio, and can better anticipate which investment risks might materialize.
Every addition to my portfolio means another company I need to understand and stay up to date with, along with staying up to date with all their competitors as well. Some investors argue that maintaining a concentrated portfolio is a bad idea because if one investment goes bad your portfolio takes a major hit.
However, my experience has proven the opposite to be true: because I spend so much time understanding all my holdings, I can proactively avoid risks before they become a major problem because I understand all my holdings so well. There’s no need for me to diversify as much because I’m fully aware of the investment risks that I’m taking on.
Some investors say that diversification reduces risk because you reduce the weighting that each holding has on your portfolio, but my experience and the experiences of countless other investors have proven that it’s possible to maintain a concentrated portfolio and still keep investment risk low.
Never underestimate the power of knowledge, especially as an investor. Knowledge does more than inform our investment decisions – it can also be used as an indirect way to reduce investment risk.
Don’t Ever Make Investment Decisions Based on What Everyone Else is Doing
There are no “secrets” when it comes to achieving success as an investor, but there are several ways for an investor to bring ruin upon themselves in the blink of an eye. One of those ways is to make investment decisions based on what everyone else is doing.
There’s a major difference between discussing investment ideas with others and blindly following what everyone else is doing.
Discussing investment ideas and topics with other investors is fine. In fact, I strongly encourage investors to exchange thoughts with at least one other investor – sometimes, our ideas aren’t as great or flawless as they seem when they’re repeated back to us or are subject to the scrutiny of others.
Problems start to arise when a healthy discussion is replaced with pressure to follow popular opinion. I’ve previously talked about the dangers of following the crowd in this article.
When you base your investment decisions on what everyone else is doing, you fall victim to confirmation bias: you are flooded with endless reasons as to why it’s a good idea to follow what everyone else is doing, but any dissenting views are quickly silenced or are simply ignored. How can you expect to find out legitimate risks regarding an investment operation if anything negative is always being suppressed?
Just because a large group of people is pushing a certain opinion doesn’t automatically mean it’s infallible. In the height of the Dot-com Bubble, every investment “guru” pushed the idea that tech stocks were all you needed to buy, and pounced on anyone who dared speak out against this. These “gurus” were quickly humbled when the Dot-com Bubble eventually burst.
When you decide to make investment decisions based on what everyone else is doing, you are essentially choosing to ignore any sort of valid criticisms and concerns. By choosing to surround yourself with opinions that reinforce your own, you willingly choose to be ignorant to any potential source of investment risk because this goes against your bias.
By making investment decisions based on your own work, the hope is that you make those decisions based on the facts – both the good and the ugly. When you understand the facts and make investment decisions based on logic rather than popular opinion, then you are cognizant of any potential sources of investment risk, and can hopefully avoid them.
Wrapping Up
Risk management always has and will continue to be, an ongoing process. Just because risks are low today doesn’t mean they will stay low forever.
Approaches to risk management can either be proactive or reactive. My experience has shown me that it’s better to deal with potential sources of problems before they materialize rather than put out fires as they appear.
No portfolio, no matter how “safe” it is right now, will stay that way unless a conscious effort is made by the investor to continuously keep investment risk as low as they reasonably can.
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