If the tumultuous movements of the stock market in recent years have not caused you to question your investing strategy, the bankruptcies of several publicly traded companies should have. Regardless of your choice of investments, whether you’re buying stocks, bonds, mutual funds, exchange traded funds, or commodities, it is impossible to completely eliminate the likelihood of certain financial conditions occurring that could harm your investment. It is possible however for you to reduce the risk associated with a particular investment vehicle by using risk management techniques.
Risk management is so important because when improperly managed it can lead you into bankruptcy. Citigroup, Bank of America, Goldman Sachs, Morgan Stanley, Wells Fargo, and other financial institutions all would have gone belly up during the financial crisis without the help of the government due to poor risk management. Lehman Brothers, Washington Mutual, and Bear Stearns were not fortunate enough to get government help with their poor financial decisions.
What is Financial Risk?
Financial risk is the risk that you take when purchasing any investment that relies on debt financing. This type of risk is one that every single investor needs to be aware of because financial risk can affect your ability to recoup your principal and affect the rate of return on an investment. The biggest reason that most companies become insolvent and declare bankruptcy is the inability to meet their financial obligations due to having too much debt.
Before investing in any company, it is imperative that you measure all of the risks involved – market risk, liquidity risk, credit risk, operational risk – so that you know exactly what you are dealing with. The first rule of investing is to preserve your investment capital. Failing to properly assess all of the risks involved with an investment can result in a loss of capital. Your goal should always be to maximize the rate of return on an investment while simultaneously keeping financial risk to a minimum.
Diversification Can Reduce Risk
As the recent financial crisis has proven, poorly managed risk can drive a company into the arms of bankruptcy. For this reason, you should look to invest in companies with relatively low debt levels and enough free cash flow to service their existing debts. That means a highly leveraged company with a high debt to equity ratio and a significant amount of long term debt maturing soon is an investment no-no. Managing financial risk can mean the difference between earning a reasonable return on your investment or losing all of your investment capital.
Use diversification as a strategy for reducing the risk of an entire investment portfolio. If you want to buy shares in a high risk small cap or penny stock, you should make sure that this investment is a small amount of your portfolio. Your core holdings should be solid stocks and funds with plenty of cash and limited debt exposure. Balancing out higher risk investments with lower risk investments is an effective strategy that will keep you from losing your shirt in the market.
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