Every transaction you enter into, regardless of how innocent it might seem, brings with it a certain amount of risk. The risk level typically aligns with the level of return you can reasonably expect. This is where the old saying of “bet big, win big” comes from.
It would be a mistake to assume that you can ever get to a point where you have eliminated risk entirely. Seasoned investors, in particular, will tell you that this is impossible. Instead, you need to mitigate that risk – meaning have a plan in place so that you can take action if things don’t necessarily go your way.
By paying attention to a few key lessons now, you’ll be in the strongest position possible when facing that risk later in your career.
Why Diversification Matters
The number one lesson to learn about risk management is that diversification is not a recommendation but a requirement. You need to spread your investments across various asset classes so that there is no one point of failure you need to worry about.
Remember the phrase we all grew up hearing, “Never put all your eggs in one basket?” Whoever coined that phrase was talking about investing, whether they realized it or not.
You would never put all of your money in stocks, for example – the market itself is too volatile. You would also want something a bit more stable, like bonds. If you’re getting into real estate, you should never focus exclusively on single-family homes. You would want to combine things and venture into multi-family rental properties or commercial real estate.
Diversification is also part of the reason why wholesale real estate appeals to so many. Here, you’re working with both a buyer and a seller on a transaction. You get the seller to agree to one price and the buyer to agree to a higher one, keeping the difference as your profit. You’re making yourself valuable to two different categories of people and are spreading out your overall portfolio risk in the process.
Research is King
Another crucial step to getting better at risk management involves conducting ample research and due diligence before entering any transaction. In no uncertain terms, the best decisions are always the most informed decisions.
To continue with the real estate example, you would never agree to buy a house without looking at it first. You would want to look up the local market to see the quality of the school district and get information about nearby points of interest. You would look into the property’s history to see if there are any issues that might impact its value. You would likely have an inspection conducted to get the seller to address anything major before you agree to further discussions.
You would do all this ahead of time so that you know exactly what you’re dealing with. Any type of investment that you make, even something as seemingly straightforward as the stock market, needs to be looked at with the same careful lens. This is the only way to make the most informed choices that you can to mitigate risk whenever possible.
The Importance of Clear Risk Tolerance Levels
An idea worth reiterating is that risk will always be present in investment in some form or another. Therefore, you need to decide prior to building your portfolio just how much of it you’re comfortable dealing with.
There are certain types of investment that are mostly low risk. A bond would be the classic example. But bonds also have very slow rates of return – possibly too slow for your liking. Other types of investment may generate higher returns much faster, but they come with a tremendous amount of risk.
Regardless, you must decide your risk tolerance level before doing anything else. That way, you can take steps to make sure you never cross that threshold. You can employ stop-loss orders in volatile markets, for example.
Having an Emergency Fund
Finally, it’s always important to have an emergency fund in place for those situations where things don’t necessarily go your way.
You should never over-extend yourself to the point where virtually any loss will equate to a total loss. Having an emergency fund means having a pool of money to draw from so that even if you get hit fairly hard, you still have the resources necessary to keep going.
This also underlines the importance of having a long-term perspective when it comes to risk management, especially when dealing with market fluctuations. History shows that there will be periods when the housing or stock markets suffer. Those periods may even extend far longer than we would like. But over time, things do trend upwards, slowly and surely.
You need to be able to weather those fluctuations, and only part of that involves having the resources needed to do so. You also need the mental agility to withstand whatever life throws at you, too. Just because a stock is down on a Monday doesn’t mean you would immediately sell. You’d probably wait to see if it rebounds on Tuesday or Wednesday. The same logic holds true of your entire portfolio, but you’re not talking about hours or days. You’re talking about years.
Risk Management Requires a Long-Term Commitment
In the end, risk management is something that must be honed over time. There will be times when your investments don’t plan out the way you thought, which might have a negative ripple effect that you can feel across the rest of your portfolio. But if you go into a situation with a plan in place to address risk in a logical, forward-thinking way, the reverse will happen, too.
You’ll be left with an ability to adeptly manage risks that will carry you forward for years to come. You’ll be able to properly safeguard your portfolio regardless of the asset type you’re talking about. Everything you’re involved in will come together to form something more powerful as a collective than any element could be on its own.
You’ll also have a clear pathway for more stable, sustainable returns – which in and of itself is the most important benefit of all.