How to Evaluate Risk in an Investment
Even amateur investors know that investing requires you to balance potential rewards with risks. It’s important to understand the possible risks you face when making your investments, and balance your portfolio so that no single asset or strategy can work against you. But how can you accurately estimate the risk of a given investment, and balance your holdings in a way that makes sense for your goals?
Types of Risk
Risk, when it comes to investments, can be defined as the probability of losing money or failing to generate a return. For example, if you buy shares of stock in a new company, there’s a chance the company could go under, causing you to lose what you invested. The significance of this chance will vary from company to company, and can be understood as the risk of that investment.
With many different assets and funds to choose from, there are many different types of risks to consider, including:
- Market volatility. Most assets are subject to the whims of market volatility. The stock market, for example, is known for its frequent daily fluctuations, rising and falling in price, in response to good or bad news about the economy or about the individual companies that make up its indexes. A recession, depression, or specific sector collapse could wipe out your funds if you aren’t careful.
- Credit and reliability. Occasionally, you’ll purchase an investment whose value depends on the ability of an individual or organization to perform or meet certain financial responsibilities. For example, in mortgage-backed securities, you’ll be depending on homeowners to continue paying their mortgages, and there will be different tranches representing homeowners of different credit ratings. The lower the credit rating, the higher the risk of nonpayment—and therefore, the collapse of investment.
- Performance. Performance is much more difficult to measure, but it’s still important to consider. If you’re investing in a company, you’ll need to know how that company operates, especially when compared to its competitors—under this leadership, does it have a good chance of turning a profit? If you’re investing in real estate, you’ll need to understand how the neighborhood and local real estate market work; will you be able to charge a reasonable amount for rent, or eventually sell the home for a profit?
High-Level Assessments and Balancing
You can start evaluating risk by understanding the risks inherent to each class or type of investment you add to your portfolio. For example, as a general rule, bonds are a “safer” investment than stocks; this isn’t always the case, but bonds typically offer a stable, consistent return, while stock performance depends on a complex tapestry of other factors. That said, stocks typically offer a much higher return over time. The best approach for most people is owning some mixture of these assets, capitalizing on the higher returns of stocks and lower risks of bonds.
Balancing your portfolio this way is ideal if you want to follow the standard advice of decreasing your exposure to risk over time. As you get older, you’ll become less tolerant of risk; you’ll have more assets to protect, and less time to make up the difference if you suffer a catastrophic loss. Accordingly, many people shift from riskier assets to safer assets gradually over the course of years, relying on general rules and high-level assessments to guide them.
Analyzing Individual Investments
Still, general rules will only get you so far. Individual assets and investments within a given category will vary in terms of risk and potential return, and it’s your responsibility to evaluate them. Measuring risk as an amateur is incredibly difficult, especially because so many variables are “hidden.”
You can start by measuring what you do know. What is the credit rating of individuals or entities tied to this asset? How stable does this neighborhood seem? What are this company’s financials like? There are hundreds of questions you can ask to get a better idea of how this asset might perform in the future—and how stable it might be.
From there, you can assess risk based on your own uncertainty. Is this a relatively new type of company, without much historical precedent for the business model? If so, it can be considered riskier. Do you have little personal experience with this asset, or are you unsure how the market might respond to it? Take this as an indication of personal risk as well.
Guarding Against Risk
It’s your job as an investor not just to understand and approach risk according to your personal risk tolerance, but also to guard against risk whenever you can. Complementary investments, diversification, and insurance can all help protect you in case of an investment failure, so make sure to explore your options and prepare yourself for these potential developments.
