Investing entails some risk. When it comes to government bonds, the risks are modest, but when it comes to stocks, options, and commodities, the dangers might be significant. The greater the investor’s willingness to take on risk, the greater the possibility for significant returns. Great investors, on the other hand, understand that risk management is more important than profit, and that proper risk management is what leads to lucrative investing.
Here are 7 investment risk factors and how to avoid them
1. Structural Risk
Structural risk affects all investments. The terms structural and systemic risk are interchangeable. These are external market hazards that have the potential to affect an entire industry. Because it affects all landlords, an eviction moratorium (such as the one imposed by COVID) is a structural risk in real estate investing. You can limit or minimize most other types of dangers, but this one is far more difficult!
Examine The Structure You’re In
With any investment, there is a chance of structural failure. Most real estate investors, on the other hand, feel that structural risk has a considerably less impact on real estate. I tend to agree with you. With real estate investments, a single tweet will not cause a large valuation fluctuation like it can in the stock market. Setting yourself up to get through it is the best way to reduce your risk. Most essential, invest in strong assets that will rent and have enough cash on hand to weather a disaster. Only if you are forced to sell will you actually lose money in real estate. You will not be forced to sell if you have reserves in the bank.
2. Political Risk
Commodity investors, such as those who invest in oil, are well aware of political risk. Investors were concerned that if Iran threatened to close the Strait of Hormuz, the price of oil would become more erratic, putting their money at risk. The turmoil in Haiti, as well as terrorist attacks on oil pipelines, has injected artificial volatility into the oil and commodity markets. Furthermore, difficulties relating to land claims in Southeast Asia, as well as tensions between North and South Korea, have shook the region’s markets.
Keeping up to date with political news
Because most events occur without warning, socio-political risk is difficult to prevent, but having strong and fast departure points as well as hedges is the best approach to weather socio-political storms.
3. Dividend Risk
The danger that a company’s payout will be cut or reduced is known as dividend risk. This is an issue not just for those who rely on stock dividends to supplement their income in retirement, but it also causes the stock to lose value as those who were holding it for the dividend switch to other dividend-paying stocks.
Maintain a well-balanced portfolio.
Dividend risk can be mitigated by diversifying your portfolio with various dividend-paying stocks. If the dividend is the only reason you own the shares, sell as soon as possible after the adjustment is announced.
4. Allocation Risk
Have you checked your 401(k) recently? As you get closer to retirement, you’ve probably heard that maintaining the right asset allocation is critical to risk management. Furthermore, 401(k) providers must disclose fees linked with investment products under federal disclosure standards. Stocks should make up a larger portion of your portfolio as you get younger, and bonds will gradually take over as your primary investment type as you get older.
Invest in a target date fund with a low expense ratio.
Investing in a low-fee target date fund will help you manage your allocation risk and costs when it comes to investing in your retirement account. If you don’t have the skills or experience to manage your own portfolio, seek the advice of a competent financial counselor.
5. Business Risk
The most well-known and feared investment risk is business risk. It’s the possibility that anything will go wrong with the company, causing the investment to depreciate in value. A disappointing earnings report, a change in leadership, outmoded products, or malfeasance within the organization are all possible dangers. Investors understand that projecting the risks associated with owning shares in a firm is practically impossible due to the enormous number of conceivable risks.
Purchasing a put option
The best approaches to protect against company risk are to purchase a put option to protect against a major decline or to arrange automated stops.
6. Interest Rate Risk
When interest rates rise or fall, there is a risk of losing money. You transfer that risk to the lender if you have a fixed-rate loan. If you have an adjustable-rate loan, though, you may be subject to escalating interest rates. In that situation, your payments may increase, lowering or eliminating your cash flow.
Manage It Through Portfolio Diversification
Market risk can be managed in a variety of ways. Obtaining fixed-rate loans and purchasing for cash flow rather than speculation on appreciation are excellent places to begin. Diversifying into different product categories and locales is also a good idea. Although I am not a big believer of investing across the country, different communities within a city can provide enough variety to mitigate risk. I also like the notion of owning a mix of single-family houses, condos or townhomes, and multi-unit buildings. I believe it has the potential to diversify more into commercial real estate, but I do so with caution. Buying assets you don’t understand might often pose a greater risk than the advantage of diversification.
7. Risk at The Asset Level
Not all properties are treated equally. Some assets perform better than others, while others require specialized management. Temporary housing is an example of this. Some real estate investors I know have decided to turn some of their rental properties into halfway houses. They did this since renting the house by the room allows them to generate substantially more cash flow. The issue is that the asset’s optimum application was not a halfway house. Neighbors began to complain, and there was a lot of turnover. They rapidly discovered that short-term rentals need a great deal of effort. They converted the homes back after their failed experiment because it is more of a business than an investment.
Know Your Asset Better
One of the worst blunders I made in my career was purchasing an extended stay hotel with the intention of turning it into an apartment development. Many of the rooms came equipped with full kitchens, and those that didn’t could simply be transformed. Unfortunately, I was unaware that the city would not allow me to turn the property into an apartment, so I was forced to operate a motel in Missouri from my Colorado office.
The property manager I hired stole money, vacancies were at an all-time high, and hotel taxes substantially exceeded my apartment’s pro forma. I had no idea what I was getting myself into. I eventually sold it to a local buyer who could keep a closer eye on it. He was making money last I heard, but I was out six figures.