Updated: August 28, 2018
How do you manage risks, especially in investing? To answer this question, we must first define what risk is, then learn how risks are typically handled in real life situations.
And this is our simple lesson for today, Risk Management 101.
What is risk?
It is the potential of loss, which is an undesirable outcome, resulting from a given action, activity and/or inaction.
That definition comes from the Wikipedia entry of Risk and if you think about it, risk is basically “something bad” that we don’t want to happen.
So examples include failing in a test, getting sick, losing a basketball game, hurting yourself in a car accident or losing money in an investment.
Four Basic Ways To Manage Risk
The first option is to eliminate the risk. For example, if you don’t want to fail in a test, then don’t take the test at all. It’s pretty straightforward.
And when it comes to investing, if you don’t want to lose money, then don’t invest at all.
The second option is to lessen the chances that the undesirable outcome will happen. If you don’t want to get sick, then you can eat a balanced diet and exercise regularly. You won’t avoid getting sick, but the chances are greatly reduced.
In investing, you have a lower chance of losing money if you invest in low-risk investment products such as money-market funds or treasury bills.
The third option is to transfer some of the risk to another party. For example, rather than playing 1-on-1 basketball, you can opt to play 3-on-3. If you lose the game, then the “agony of defeat” is felt not just by you, but shared with your teammates as well.
When investing in a business, you can opt to get partners. If the venture fails, then you won’t lose as much money as compared to putting up the business alone.
The last option is to accept the risk and prepare for it in case it happens. Yes, you don’t want to get hurt in a car accident, but you still went ahead and used the car to go to the place you want to be.
You probably just said to yourself, “If it will happen, it will happen.”
When putting money in a high-risk investment, you should to some degree, be okay with losing money in the end. You should be able to accept that fact and prepare an action plan in case it happens.
Risk Management Planning
Now that you know the four basic ways to manage risk, you can now plan for it using a combination of strategies.
Let’s say you want to invest in the stock market, then you can manage the risk of losing money in it by doing the following:
- Avoidance: Putting off investing until you learn and fully understand how the stock market works.
- Reduction: Lessen the risk of losing money by following the advise of stock market experts.
- Sharing: Share possible losses with other investors by putting your money in an equity fund instead.
- Retention: Investing only money you can afford to lose.
There are many other ways you can manage risks when it comes to investing in the stock market. One example would be to do strategies such as Cost Averaging.
The Financial Impact of Dying
What will happen to your family when you die? Will they experience financial difficulties? Where will they get the money for their daily expenses?
How do you manage this type of risk?
- Avoidance: Build massive wealth while you’re still alive so that your family will have lots of money when you die.
- Reduction: Create multiple sources of income for your family so that cashflow won’t stop when you pass away.
- Sharing: Buy life insurance to effectively share or “transfer” the financial burden of your death to the insurance company.
- Retention: Accept the fact that life in unpredictable and live everyday as if it’s your last.
This concludes our short lesson on Risk Management. I hope you learned something from it. Do leave a comment below if you have any questions, and please don’t forget to subscribe below if you haven’t yet done so. Thanks!