How to Manage Investment Risks

Any investment, even those that seem reliable at first glance, carries certain risks. Novice investors often underestimate these risks, which can lead to a lack of expected returns, or even loss of a portion of their invested capital. Financial risks for investors are inevitable – they cannot be entirely avoided, but they can and must be managed. It is essential for investors to understand what risks are associated with different investments and how to minimize these risks.

Types of Investment Risks

An investment risk refers to the probability of losing invested capital or failing to receive anticipated income from investments. There are two primary categories of investment risks: market risks and non-market risks.

Market risks are caused by fluctuations in asset prices and the overall conditions in financial markets. Examples of market risks include the risk of asset price decreases, bankruptcy risk of a company, and the risk of dividend non-payment (which we will delve into in more detail later). These risks are directly related to the value fluctuations of your investments: in unfavorable market conditions, securities may depreciate, companies may lose profits, which affects your income.

Non-market risks, in contrast, are not directly related to price movements in the market. They arise from external circumstances, such as economic, political, and other factors. Non-market risks may include economic factors (economic crises, inflation, interest rate changes), political factors (government instability, legal changes, sanctions), and various force majeure events (such as natural disasters or pandemics). Such events can negatively impact the value of investments, even if the chosen instruments themselves are reliable.

Risk of Asset Price Decline

One of the most obvious market risks is the risk of a decline in the market price of a purchased asset. Simply put, you have bought a stock, bond, real estate, or another investment object, and its value decreases over time. There can be numerous reasons for a price drop. A company's shares may depreciate due to declining revenues, business failures, or negative news releasing in the market. Real estate can lose value due to an economic downturn, oversupply, or deterioration of the property itself. Even commodity prices (such as oil or gold) are susceptible to fluctuations in supply and demand.

For investors, a decline in the asset's price represents a direct loss, especially if the asset needs to be sold during this period. How can this risk be reduced? While it is impossible to completely eliminate market fluctuations, investors can strive to select quality assets. Conduct research before purchasing: evaluate the financial health of the company, industry prospects, property condition, etc. Furthermore, it is advisable to purchase assets at a justified price – avoid paying inflated prices for hyped securities at market peaks. Well-chosen assets purchased at reasonable prices are less likely to experience sharp declines and offer better chances to withstand temporary price downturns.

Risk of Company Bankruptcy

Another significant risk for investors is the bankruptcy of the issuer, that is, the company or organization in which the funds have been invested. Any company can go bankrupt – whether it is one that issues stocks or bonds, a real estate developer, an investment fund, a bank, or even a sovereign state (in the case of sovereign default). When bankruptcy occurs, investors often lose a substantial portion of their invested funds: shares may quickly become worthless, payments on bonds may cease, and recovery of any part of the investment can be a challenge.

Minimizing bankruptcy risk requires a careful selection of investment objects. Before purchasing a company's securities, it's vital to study its financial reports: Are revenues and profits growing? What is the extent of its debt? Is its market position stable? Reliable, profitable companies with moderate debts are far less likely to go bankrupt. Of course, even industry giants can experience crises, but the probability of complete failure for financially stable firms is lower. Additionally, do not invest all your money in a single company – diversification among issuers (which will be discussed later) can protect your portfolio if one firm were to fail.

Risk of Dividend Non-Payment

Many investors purchase shares anticipating regular dividends – a portion of the company's profits distributed to shareholders. However, dividends are not guaranteed: a company may reduce or even eliminate its dividend payments. This usually occurs if the company's profit declines or financial difficulties arise, such as reduced income or increased debts. At times, even in favorable situations, management may decide to reinvest profits back into the business, leaving shareholders without distributions.

For investors focused on generating dividend income, such a decision can be quite disappointing. First, it means they miss out on anticipated investment income. Second, the stock price may not rise, as part of the company's appeal for investors was precisely the dividend payout. Consequently, the investor’s yield and associated risk may become unbalanced: expected returns decline, while market risks (stock price fluctuations) remain unchanged. To reduce the risk of dividend non-payment, it is crucial to carefully select dividend-paying stocks – favor companies with a long history of stable payouts and a solid financial position. Moreover, do not rely solely on dividends as the only source of income: it’s always beneficial to have alternative methods to generate profit from investments (such as stock price appreciation).

Non-Market Risks

Non-market risks are those not directly related to market behavior. They are caused by external circumstances that may impact your investments. These risks encompass economic and political conditions, changes in legislation, and other global factors. For instance, an economic crisis or recession may lead to decreased profits for companies in nearly all sectors, which in turn affects stock prices and other assets. High inflation erodes your savings and diminishes the real return on investments – money loses purchasing power. Changes in tax legislation or the introduction of new regulations can make certain types of investments less attractive (for example, an increase in tax on income from deposits makes them less profitable). Political instability, revolutions, wars, and sanctions all impose risks on investors operating in affected regions, regardless of the condition of the specific companies involved.

Non-market risks are harder to predict and control, as they are unaffected by the investor’s actions. It is impossible to fully eliminate the impact of global events. However, the influence of these risks can be partially mitigated. Diversification across countries and sectors helps ensure that events in one country or sector do not significantly cripple the entire portfolio, alongside selecting strategies that account for the macroeconomic environment. For instance, during periods of rising inflation, it may be wise to invest in instruments with yields above inflation, while during political instability, it is prudent to avoid investments in affected regions. The key is to recognize that external factors exist beyond market fluctuations and to evaluate investments accordingly.

How to Assess Risk Levels

Having discussed the main types of risks, the question arises – how can one evaluate the risk of a specific investment before committing funds? In other words, how can one gauge whether the risk associated with a particular investment instrument is high or low?

First, it's essential to understand to which category the investment instrument belongs. Different assets come with varying levels of risk. The least risky investments tend to be secure fixed-income instruments that guarantee capital return. For instance, bank deposits and government bonds are typically considered low-risk: the bank returns the deposit amount (within government-insured limits), while a reliable issuer pays the stipulated interest on bonds. Medium-risk levels are generally associated with balanced investments, such as mutual or exchange-traded funds in stocks, real estate investments for rent – their returns and fluctuations are moderate. High-risk investments usually pertain to individual stocks, especially those of young startups or cryptocurrencies. Such assets often boast high potential returns but are marked by extreme price volatility and a significant likelihood of considerable losses.

The rule always applies: the higher the potential yield, the higher the associated risks. Low-risk investments allow for modest but stable returns. On the other hand, the most profitable assets can sharply amplify your capital while exposing it to considerable risks. Each investor must determine their balance between desired profits and acceptable risk levels. A young investor with a long investment horizon (e.g., 10-20 years) may benefit from taking on more risky assets in their portfolio – they have ample time to recover from potential downturns. Conversely, someone looking to use investments as a source of current income (for example, a retiree) would be better off selecting the most secure instruments, even if the returns are lower.

There are also external risk indicators available to simplify this task. Many investment products are tagged with risk ratings. For instance, bonds are assigned credit ratings that indicate their reliability – from the highest AAA to lower grades – and it is wise for investors to pay attention to the issuer’s rating. A high rating usually signifies a low risk of default on the bond. Another example is that exchange-traded funds (ETFs) are often classified according to risk level on a scale (such as from 1 to 7), where 1 represents the safest investments and 7 denotes those with the most volatility. Overall, a combination of these indicators and sound judgment can help investors perform their risk assessments on each instrument.

How to Reduce Risks

Naturally, every investor wishes to achieve profits while avoiding significant losses. Once the risks of each asset are assessed, it’s necessary to consider how to reduce the adverse impact of these risks on your capital. There are several key strategies that can help mitigate an investor’s financial risks to an acceptable level:

Diversification – spreading funds across various investments to ensure that the decline in value of some assets is offset by the income of others.
Defensive instruments – investments in stable assets (such as bonds, gold) that retain value during market crises and serve as a “safe harbor” for capital.
Stop-loss orders – using specific sell orders to liquidate assets when their prices drop to a certain threshold, effectively limiting potential losses.
Portfolio rebalancing – periodically adjusting the structure of your investment portfolio to revert asset allocations to originally planned levels.

Let’s consider these methods in more detail.

Diversification

Diversification refers to spreading capital across different instruments and directions. In simple terms, it means “not putting all your eggs in one basket.” This approach significantly reduces overall risk: if one asset incurs a loss, the remaining investments can compensate for those losses.

Proper diversification can occur based on various parameters. Firstly, by types of assets: for example, part of the funds could be allocated to stocks, another part to bonds, and another to real estate or gold. Secondly, diversification can be achieved through different issuers and sectors: assets can be distributed among stocks of various companies from different industries, bonds from diverse issuers, and multiple real estate objects, etc. As a result, a balanced portfolio is created. If one particular investment significantly depreciates (for instance, the stock price of one company plummets), then other investments will help offset those losses.

It is important to understand that diversification does not eliminate risk entirely, but it does smooth out portfolio fluctuations. With a thoughtful allocation of assets, downturns in certain positions are balanced by gains in others. Hence, a diversified portfolio typically grows more steadily over time, without sharp declines, providing greater psychological comfort for investors and safety for their capital.

Defensive Instruments

Defensive instruments are the most stable and reliable assets that maintain their value even during market crises. Prices for such assets either barely drop during tough periods or may even tend to rise when the rest of the market is unstable. Classic defensive instruments traditionally include gold and highly reliable bonds (primarily government bonds). For instance, during a stock market crash, bonds typically experience minimal price drops. They can be sold without incurring significant losses, allowing the freed-up capital to be directed towards purchasing undervalued stocks, thus effectively reallocating capital. Gold often increases in value during times of financial instability, serving as a “safe haven” for investors. Even when it temporarily drops in price alongside the rest of the market during a panic, it tends to recover losses faster than stocks.

To some extent, cash can also be considered a defensive asset – holding part of your capital in cash or in a bank deposit. Having cash on hand instills confidence during any crisis. However, this approach has its downsides: during high inflation, cash quickly loses value. Thus, simply holding all assets in cash over the long term is unwise – investing them in productive ventures is essential.

Defensive instruments usually comprise a smaller or larger portion of each investor's portfolio based on their investment strategy. If high risks are not appealing to the investor, they tend to emphasize such stable assets. A more conservative approach generally means a larger proportion of gold, bonds, and cash equivalents in the portfolio. Conversely, aggressive investors hold minimal capital in defensive instruments – often just a “safety net” for crisis management – investing the bulk of their capital in riskier but more lucrative projects.

Stop-Loss Orders

A stop-loss is a specific exchange order (instruction) to sell a security if its price falls to a certain level. Essentially, the investor sets a predetermined price threshold at which they are unwilling to endure losses. If the price declines to this threshold, an automatic sale of the asset occurs. A stop-loss order disciplines investors and protects them from excessive losses: as soon as the decline reaches a critical threshold, the position closes, preventing further losses from escalating. This practice helps limit potential losses and, consequently, reduces investor risks.

However, there are nuances to stop-loss orders. Firstly, triggering an order does not always guarantee a sale at the exact specified price – during a rapid market crash, the asset may be sold at a slightly lower price than anticipated. Secondly, if a stop-loss is set too “close” to the current price, it may trigger due to short-term price fluctuations (market noise), leading to an unnecessary sale, missing potential rebounds in price. Therefore, using stop-loss orders requires skill: reasonable levels must be set, considering the specific security's volatility. Beginners are generally advised not to get overly reliant on this strategy, as improper stop-loss settings can cause more harm than good. Overall, stop-loss orders are tools more suited for experienced investors who already have the ability to analyze price movements and wish to automate risk management.

Portfolio Rebalancing

Portfolio rebalancing is the periodic review and restoration of the original structure of your investments. Over time, some assets in a portfolio may appreciate while others lag behind, causing the allocation of investments to deviate from planned levels. This alters the overall risk of the portfolio: typically, growing more volatile assets start to occupy a larger portion than originally assigned, making the portfolio riskier than intended. Rebalancing reins in that balance.

It is advisable to analyze the composition of your portfolio at least once a year and adjust it as necessary. For instance, if the investor initially allocated 60% of funds in bonds and 40% in stocks, and after a year the market situation changed such that stocks significantly increased in price and now account for about 70% of the overall value of the portfolio, while bonds account for only 30%. As stocks are a high-risk instrument, the overall risk of investments has noticeably increased. To revert the portfolio to its initial proportion and planned risk level, the investor can sell part of the appreciated stocks and use the proceeds to purchase bonds. After such rebalancing, the allocations will again become approximately 60/40, reducing the portfolio's risk to the intended level.

Rebalancing can be conducted with varying frequency: yearly, quarterly, or when allocations deviate beyond a designated threshold (for instance, if any part exceeds the target by more than 5-10%). The key is to have a predetermined portfolio structure (asset proportions) from the outset and stick to it while reassessing assets as necessary. Regular rebalancing allows you to “lock in” profits from overheated assets and reallocate them into underperforming sectors, effectively allowing you to buy low and sell high systematically. This keeps risks in check and prevents the portfolio from becoming overly one-sided. In the long run, disciplined rebalancing aids the investor in achieving stable returns aligned with their chosen strategy without undue turbulence.