Dealing With Risk

Fear is an emotion that will often be experienced when investing. This is good as it means that the investor realises that there is always an element of risk involved in investments. Fear has a way of keeping  a person's greed in rein and hopefully will act as an important check from allowing himself to run into financial difficulties by investing beyond his means. To succeed in the long-term, the investor has to accept that risk is an inherent part of investing.

Understanding all the risks associated with a particular investment is not the end of the story. Even after meticulous studying a potential investment to identify and assess the different risks involved, many investors still trip up during the last crucial steps of their investment decision.

This often happens when it comes to dealing with valuation risk. Unlike the other risks, valuation risk relies more on an individual's prediction of an investment's future value, in other words - it is really a judgement call. Take for example a company that your research shows has a solid business model, great management and glowing business prospects. This company looks wonderful and you really feel compelled to buy its stock.

The problem is that there may be loads of other investors have also discovered this company and already bought its stock, which has driven  its share price up froma price-earning or PE ratio of 8 time to 30 times over the last year. Obviously there is a higher risk of investing in the shares at the current inflated price unless you are really quite sure the company will be able to deliver strong earnings growth over the next few years to justify the its high valuation. Even than, that leaves little room for error.When market expectations are running high, the slighest bump down the road could cause a significant decline in the stock price.

Knowing how much to pay for an investment vis-a-vis its valuation is one of the most important steps to successful investing. This brings us to what is termed as timing risk, which is the risk of buying, or selling, the right asset at the wrong time. While there is no surefire way to beat the market and financial planning professionals generally advise against timing your investments, many investors may have found from experience that when you buy or sell does make a difference to the returns.

Another trap that many investors fall into is called 'force-of-sale risk'. This usually happens when the investor puts himself in a position where his investment must appreciate within a given time frame. An example of this is when you buy a stock with money that you know you would need for the downpayment of your new house in three months time. Even though you are pretty certain that you bought the stock at a good price, you are still in a disadvatageous position as there is no guarantee it wil be able to rise in three months. To be sure, the stock could well be trading around the same price or even lower than the time, which means you would be forced to sell at a loss to raise funds to meet your obligation. It usually goes without saying that a person who is forced to sell his investment under such circumstances probably has also not paid attention to the importance of spreading his exposure risk across a few investments.

As can be seen, the risks that we have discussed are within your control and can be avoided by having a strict set of money management rules. For example, rules that stop you from purchasing a stock when its valuations appear inflated, or during periods when market sentiment has become unreasonable optimistic. More importantly, always ensure that you do not over-commit on any single investment and have sufficient financial resources to see investments through a reasonable period of time.

Having said that, there are a number of ways that an investor can manage the risk of his investment portfolio. One common method is diversification, which will ensure that you do not put all your eggs into one basket. through careful selection, diversification can help to mitigate country, currency and industry risks. For example, investing in a number of stocks from a particular country or specific industry would expose your portfolio too heavily to negative developments that affect those particular stocks.

Another way to minimise risk is to invest in a professionally managed fund. These days, there is a wide range of funds for investors with different risk profiles. For those, with modest amounts of capital, investing in a fund is recommend. Not only will you benefit from the collective department of the fund manager's team, you will also be able to diversify your risk by buying a multi-country, multi-sector fund.

If you prefer to invest your own money, it may be worth considering the advice of some professional finance advisors, who advocate setting up a dollar cost averaging plan. This is a system that requires you to make your investment  purchases at regular intervals and set amounts, regardless of whether the market is moving up or down. Instead of investing a lump sum amounts, dollar cost averaging ensures that the average cost of your portfolio is spread out over several years and provides insulation against changes in the market price.                                                                             -Herman Phua - Octant Consulting