Understanding Risk in Investing

Big risks offer big opportunities, but you have to be smart!

Understanding Risk in Investing

When it comes to building wealth, investing is the most powerful tool that most of us have access to. But wherever you find opportunities to make money, you find risks—and investing is no exception. Indeed, nowhere is the balance of risk and reward more obvious than in the world of investing.

But while the fact that risk and reward are related in investing may be obvious, the complexities of the relationship may elude newer investors. So before you dive into the world of investments—especially if you have plans to become an active investor—take some time to learn a bit more about how risks work in investments.

Stability and Volatility

At its most basic, the relationship between risk and (potential) reward in investing is about volatility. How much will a stock (or other investment) change in value, and over how short of a time period? That’s the question that investors should be asking themselves about every stock, bond, or other investment that they consider.

Generally, big companies that have been around for a long time will have valuable stocks that are relatively stable in value. If you buy stock in a massive company like General Electric, you can be pretty confident that your investment will not be lost, because General Electric is unlikely to go out of business anytime soon. But you can also be reasonably sure that you’re not going to double your money, because General Electric is not going to double in value anytime soon, either. It’s too large and too well-established to grow that fast.

On the other side of things are very small companies that may grow very fast—or may go belly-up. Their stocks tend to be cheap, which is why they are often called “penny stocks.” These stocks could explode in value, but if you aren’t lucky, you could see your investment evaporate.

You’ll also find similarly price bonds and even penny cryptocurrencies. Again, these are opportunities for big gains—but they’re risky.

Diversify your portfolio.

You’ve heard that you shouldn't keep all your eggs in one basket, right? Well, it’s the same with investments.

There’s something called concentration risk, and it’s the bane of rookie investors. You need to be careful to spread your bets around, so that one bad mistake can’t upend your entire portfolio. You can only do so much about things like market risk—the risk that the whole market takes a dive—but concentration risk is within your control. Be smart and keep yourself diversified.

Market Order, Shorting Stock, and More

When you buy a stock, your potential loss is capped at whatever you put into the stock. In the worst case, the stock could go down to zero, but no further. But you have ways to bet on the stock market (and other investment markets) in ways that could expose you to significant, and even unlimited, losses. Naturally, the risk comes with potential rewards—but be careful!

If you short-sell a stock—that is, promise to sell it without owning it—you could make money by waiting until the price drops, buying it at a discount, and then selling it as agreed. But you could lose money if the stock goes up in value, and because there’s no hard cap on how much the stock could soar, your losses could be extreme.

Short-selling is a market strategy that can increase your risk, but you can also use strategies to lower risks. Stop-loss orders are a great way to put a cap on your losses—they’re standing orders to sell investments at a certain price, and your broker will execute them when they are triggered. You can also use limit orders to buy stocks instead of using market orders. A limit order says you’ll only pay a certain price for a stock (or will only sell for a certain minimum). Market orders are safe to use with highly liquid stocks, because the prices you’ll get will closely match the share price, but limit orders are the way to go with highly volatile securities like penny stocks.

Trading on Margin

One of the riskiest things you can do as an investor is, naturally, one of the most profitable. Trading on margin means trading with money that you do not actually have. It’s something that your broker will let you do—well, maybe, anyway. You’ll have to keep a certain amount of value in your brokerage account to keep trading on margin, and you’ll have to pay back loans regardless of whether or not you make money.

Be aware of the fact that changes to your other investments could mess with your ability to trade on margin. Imagine this scenario, for instance: Your broker is happy to let you trade on margin based on the value of that account, but then you torpedo the value of that account by shorting a penny stock. Now your broker might call your debt—and might even sell you out of stocks to cover it.

Manage your risk.

Investing is full of sources of risk. Make sure that your investment strategy understands and uses them all properly. Remember to take into account all of your different sources of risk, as well as how they might work together. And remember to only put what you can afford to lose into risky positions.

Carlos Fox
See all posts by Carlos Fox