4 Simple Actions to Reduce Investment Risk

2021-01-05     thesmartinvestor
4 Simple Actions to Reduce Investment Risk

Risk should be the first and foremost thing on an investor’s mind when he or she sets out to deploy capital.

But risk involves having negative thoughts.

That is why many investors tend to focus on potential returns rather than think about risks because the idea of a big reward is far more appealing.

Investors also need to understand what risk is.

Share price volatility, for instance, is not risk.

Instead, risk represents the possibility of you suffering a permanent loss of capital, arising from either a loss that you’ve locked in or an investment gone awry due to poor business fundamentals.

Investors also need to know that risk is contextual, and may manifest itself differently for different investors.

That said, there are some risks that you should be wary of as they apply to investors across the board.

These relate to your understanding of the business you are investing in, portfolio composition and warning signs that may flash danger.

Here are four simple aspects investors should mull over to reduce or mitigate risks within their investment portfolio.

1. Over-exposure to a single position

Investors should assess if there is any one position within their portfolio that occupies an outsized weight compared to their other positions.

Such a large position may indicate over-confidence as the investor is hinging on that company doing very well.

This high exposure may lead to significant losses should things not turn out as expected.

Sometimes, a position could also become larger as its share price rises, resulting in the value of the position occupying a higher weight within your portfolio.

While this phenomenon is a happy problem, it does expose the portfolio to the risk of a sudden plunge should things go south.

One solution to this is to increase your stakes in other stocks in your portfolio to naturally “dilute” down the oversized position.

2. Is the yield too high?

A simple yet effective question to ask oneself is whether the dividend yield on a security seems too good to be true.

For companies sporting dividend yields close to 9% to 10%, investors should ask questions about the state of the underlying business as well as the company’s ability to sustain its dividends moving forward.

High yields are often (but not always) a signal of a declining business, whereby the yield often appears high as the dividend may decline significantly in future years.

While such examples may not always be symptomatic of a weakening business, it is worth your time to dig a bit deeper to understand the underlying causes of the apparent high yield.

As the saying goes: there is no free lunch in this world.

3. Do you understand the business?

Investors should ask themselves if they understand a business well enough to feel comfortable investing in it.

If the business seems too complicated (i.e., too many moving parts) or is a black box (i.e., no one can figure out the variables affecting it), then it may make sense to give it a wide berth.

That said, a simple understanding of the business may not always be a sufficient reason to invest in it.

For instance, it’s easy to understand a food and beverage business such as Jumbo Group (SGX: 42R), which is famous for its chilli crabs.

However, investors need to go a little deeper to figure out what drives the business, what factors impact its industry, and how its business can continue to prosper.

It also helps tremendously to know how to read basic financial statements to decipher what’s going on with the business.

The very basic aspects to look at are whether the business is profitable and if it is generating free cash flow for its shareholders.

Although the above steps may seem tedious, they go a long way to ensuring that you do not lose your hard-earned money in a dud company.

4. Are there any red flags?

Investors need to be alert and watchful for corporate announcements or events.

Businesses may occasionally report on downbeat business conditions or headwinds they face, especially so during the COVID-19 pandemic.

While some of these challenges may be temporary or transient, others could signal a structural change in the industry that affects the company permanently.

In other instances, profit warnings may result from the company being unable to cope with increased competition or weak business demand.

Investors who are aware of such news could reduce their risk level by reducing their exposure to such businesses, or sizing them smaller in the first place.

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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.

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