It is easy to be seduced by the potential upside for an investment. If the market for electric cars is growing, surely Tesla is a good investment? Or if stay-at-home fitness is the latest trend, Peloton shares are likely to fly. If inflation is soaring,
gold must be a good bet, or if interest rates are rising, it’s the time to buy banks.
This might be true, but investors also need to look at why the investment case might not work out: is a company facing new competition? Is it affected by a change in interest rates? Could the economic environment dent demand for its products? Could input
costs (energy, commodities, metals) rise? Analysing the risks is every bit as important as identifying the possible rewards.
Investors can be prone to wild optimism about a company’s prospects. An appraisal of the risks forces investors to consider whether they are investing for the right reasons. If they are investing because they are worried about missing out, or because they
see lots of other people investing, looking at the risks in more detail may help them to better decisions. There are several questions investors should ask themselves about risk:
Is there enough potential price appreciation to compensate me for those risks?
Even the best company can be a terrible investment if you pay too much for it. You need to make sure that the potential upside for any investment compensates for the risks you are taking. If an investment could see its revenue rise many times, but its technology
is early-stage, it may be a risk worth taking. If, on the other hand, the price is already high, it suggests the potential growth may already be anticipated by investors.
How much will it hurt me if the worst happens?
The risks need to match your tolerance for loss. If a company has a single product and that product goes wrong, it is plausible that a company’s share price could lose most of its value. Even if this is an unlikely scenario, you need to make sure you could
deal with it if it happened. If you are saving for a short-term goal, or fluctuations in the value of your investments keep you awake at night, this is probably not the right option or it needs to be balanced with ‘safer’ investments, so it’s a smaller share
of your portfolio.
Are there better alternatives with more compelling risk/reward?
Professional fund managers talk about ‘competition for capital’ in their portfolios. In other words, the mix of investments should offer the best available risk and reward at any given time. If there are companies that offer more reward for less risk, they
should be in the portfolio and other investments should come out. This may be too much work for private investors and can encourage excessive trading. However, it is a principle worth bearing in mind to keep a portfolio fresh and to guard against apathy, where
an investment stays in a portfolio long past its prime.
What would change the risk profile?
It is worth considering in advance what might prompt you to sell out of an investment. This may help you get ahead of the market. For example, the recent Netflix results saw the group’s subscriber base weaken and its shares slide. However, investors already
had clues – there were considerably more competitors in the streaming market, including Disney and Amazon. Equally, the all-time share price highs
achieved in November 2021 should also have raised some red flags for investors. Thinking about the potential game-changers in advance can make it easier to make decisions in the heat of the moment.
What will this investment do to the overall risk of my portfolio?
Investments can’t be taken in isolation. The risk will change depending on how you blend them in a portfolio. For example, if you buy a company that tends to be sensitive to the economic environment, like a bank, that could be risky. However, it
becomes less risky if it is balanced with more defensive companies, such as a pharmaceutical company. A well-balanced portfolio should have a range of different economic drivers, and not be uniquely sensitive to specific risks – such as interest rates, the
oil price or economic strength or weakness. It should have a blend of sectors and geographic regions. This can help mitigate risk in the portfolio.
What are the costs to buy, hold and sell the investment?
The amount you pay to trade in and out of an investment should be a factor in your calculations. If you have high trading costs, it adds to the risk of each individual investment, lowering the upside and setting a lower bar for losing capital. Your investment
platform should be helping you manage risk, not adding to it.
Considering the risks for an investment is every bit as important as looking at the potential upside. Asking the right questions on risk can help you spot problems before they arise. It brings an important discipline to investors and ensures better, less
emotional, decision-making.