What Happens When Investors Forget About Risk?

Adam Sarhan |

The short answer is you fail.

It's easy to forget now, but remember what happened to major institutions like Wachovia, Washington Mutual, Merrill Lynch, Bear Stearns, Lehman Brothers?

The long answer is that when you overlook risk, at the very least, you hinder your ability to prosper. For the purpose of this article we shall use Investopedia.com’s definition of risk:

“The chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.”

”A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.

For example, a U.S. Treasury bond is considered to be one of the safest investments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.”

There is a major (flawed) assumption that is commonly used when people think about risk: that there is an equal relationship between risk and reward. However, in the real world, most so-called “risky” investments fail. Therefore, one would be wise to step back and take an objective look at the upside (i.e. potential return) before putting a single penny to work in any investment.

Concurrently, it is imperative that a prudent investor take the time to analyze the downside of a potential investment vs. the reward. Put simply, one’s risk management strategy should entail a factor of at least 2-1, before initiating any position. That said, for every two units of potential gain, one would be willing to risk one unit. In liquid assets (capital markets) one can easily employ stops to protect the downside and therefore execute this strategy. However, in non-liquid assets (i.e. real estate or other illiquid markets) the exit strategy is more complex (since there are more variables involved) and requires a well devised exit plan.

It is important to remain cognizant of the fact that risk is inevitable and that it is an inherent part of our world. Therefore, instead of taking the easy way out and trying to avoid the subject all together (or simply “hope” that everything will be “okay”) it would be wise to take some time, understand the topic, get comfortable with the concepts involved then begin employing some of our time-tested tactics in your investment routine. All our tools and services are designed to help you minimize risk and maximize your return!

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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