How to Minimize Investment Risk

The goal of every investor is to increase their investments through capital appreciation, or through compounded interest or dividend income. While there are many ways to invest, (Real Estate, Annuities, Money Markets etc.) this article will focus on investments in stocks and bonds.

Stocks

When an individual invest in stocks, they need to be aware that stock investments are inherently risky. Experienced stock investors know that minimizing stock losses is just as important as picking stock winners. Almost every stock investor knows the importance of choosing companies that have a history of growing profits, along with having a strong balance sheet, and products or services which are in demand. Most investors also realize the importance of establishing a predetermined price range before they purchase a stock.

Use Stop Loss

While most investors take the obvious steps to prevent stock losses, many do not appreciate the importance of placing a stock loss order to minimize stock losses. A stop loss order is an instruction that is given to a broker to sell a stock when it reaches a certain price. The purpose of a stop-loss order is to limit an investor’s loss on a stock position. For instance placing a stop-loss order for 8% below the price you paid for the stock, will limit your loss to 8%. This strategy allows investors to determine their loss limit. Every investor will want to evaluate their tolerance for risk, along with other facts and circumstances, when they set a stop loss limit. When placing a stop loss order investors need to be careful to place the order at a level which is below the stocks normal range of fluctuation, or it will sell the stock on a normal downswing. For most stocks, I would advise investors to place a stop-loss limit at 8% below their entry point into the stock. Generally, if a stock’s price declines by 8% it would be reasonable to conclude, that the stock is not likely to be a winning investment. There is always the risk of losing money on stock investments, but placing a stop loss order is the surest way to prevent a losing stock selection, from becoming a disaster.

Bonds

Investing in bonds may not be as sexy, or as potentially lucrative as investing in stocks or stock funds, but investors can usually be assured of getting back their capital, plus fixed interest payments from the bond issuer. Many conservative investors choose bonds as an investment vehicle, because it is generally acknowledged that investing in bonds is safer and less volatile, than investing in stocks. Other investors put money in bonds, because they feel that investing in bonds, is a safe way to stabilize their investment portfolio through diversification. While investing in bonds is usually less risky than investing in stocks, there are still some risk that bond investors must assume. For instance bond investors face:

Inflation risk: When inflation increases, bond prices fall because the purchasing power of a bond investor’s future interest payments are reduced.

Interest rate risk: When interest rates rise, bond prices fall; conversely, when rates decline, bond prices increase.

Market risk: When the bond market declines as a whole, no bond is immune from risk.

Event risk: The risk that a bond issuer becomes involved in a leveraged buyout, debt restructuring, merger or recapitalization that increases its debt, thus causing its bonds values to fall.

Finally, there is default risk. Since bonds are essentially a loan from a company, or an organization, an investor must always consider the risk that the loan will not be repaid. U.S. Government bonds, which are issued by the U.S. Government, and backed by its full faith and credit, are considered to be almost default proof, and therefore pay a relatively low yield. Municipal bonds are not considered to be default proof, but are considered to be less risky than corporate bonds. Corporate bonds are issued by companies, and are considered to be more risky than government bonds, but less risky than mortgage backed bonds. Mortgaged backed bonds are considered to be the riskiest bonds of all, and they pay the highest yields. The Moody’s, Standard and Poor’s and Fitch rating agencies assign bond ratings, that investors should use to determine the risk factors for each of the above types of bonds.

How to Manage Risk

Bond investors will always face risk, but there are ways to reduce the risks. For example:

If bonds are held until maturity, changes in interest rates won’t have as much of an impact, because the bond issuer will be pay the total face value of the bond at maturity.

Investors can also protect themselves from changing interest rates by buying bonds with shorter term maturity dates. An earlier maturity date offers more stability from changing interest rates.

Investors can protect themselves from inflation risk by buying Treasury Inflation-Protected Securities, or TIPS. “The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.”

One of the primary goals of any good investor is to protect their capital. Simply stated, that means, keep investment losses to a minimum. Almost any successful investor will say that they have learned strategies that have helped them to minimize investment risk. It should therefore be a top priority of every self directed investor, to develop and implement a strategy, to minimize their investment losses.