In order to accomplish good investing you need to manage the risks involved. For each investment you make there are three types of risks you need to guard against: business risk, valuation risk, and force of sale risk. The following are way to protect yourself from these risks:
1. Business Risk. This is the most familiar and easily understood of all the investment risks. It is the risk of loss of value through competition, mismanagement and/or financial insolvency. Larger industries are at higher risk, such as airline and railroads. The best way to protect against business risk is franchise value. Companies with franchise value can raise their prices to adjust for any increase in labor, taxes or material costs. Stocks and bonds that come from commodity-type businesses do not come with franchise value and normally decline quickly whenever the economic environment changes for the worst.
2. Valuation Risk. Companies that appear overvalued have little room for error. If an overvalued company experiences a sales decline or does not open new locations quickly enough, then stock in that company will decline rather quickly. Therefore, always consider the price you are paying for the investment.
3. Force of Sale Risk. Never put yourself in the position where you anticipate when your stock is going to appreciate. You will put yourself at a disadvantage by doing this. By imposing time limits you are opening yourself up to high risks.
All investing carries a certain amount of risk, but there can also be gains associated with these risks. You need to weight the potential reward against the risk to decide if it is worth the investment.
In investing the more risk that’s involved, generally means the higher the return. However, these types of investments rarely have high returns. You need to find a comfort level and be able to gauge the risk of a particular investment.
Ask yourself the following three questions when considering risk:
1. Are the investments I make going to lose money eventually?
2. Will I reach my intended investment goal?
3. Am I willing to accept the higher risks involved to receive possible higher returns?
Losing money is the most common risk. There are investments you can make that will guarantee you won’t lose any money, but you will give up almost all your opportunities at getting a high return.
There are four elements that determine if you reach an intended investment goal:
The amount you invested in the stock.
The length of time you stayed invested in the stock.
The rate of return you get or the growth of the stock.
The amount of fees, taxes and inflation that have been taken out.
You need to conduct your investment strategy around a comfort level that you select. If you do not worry about the amount of risk you are facing and you don’t lose sleep over it then it is probably an acceptable risk.