Everyone knows that successful investing entails taking calculated risks. The trick is to minimize those risks while maximizing your potential profits. You can do this better if you understand the risks—and plan your portfolio accordingly.
In recent years investing has become riskier. That’s due to the increasing volatility of financial markets, less predictable international trade policies and international competition, among others.
Today’s investors have to be more flexible as a result. They need to adapt quickly to changes in financial markets and the economy. They also have to understand the risks they face.
Basically, investors in common shares face two broad categories of risk: company-specific risks and extraneous risks. Company-specific risks refer to anything about a particular company—its structure or policies, for instance—that may affect its suitability as an investment.
Extraneous risks are external factors—currency exchange rates, tariffs or economic growth and contraction, for example—that may affect many companies simultaneously. They’re things that individual companies have no direct control over.
3 types of company-specific risks
You can split company-specific risks into three sub-categories. One is asset risk. That is, the smaller a company is, the more vulnerable it is to business uncertainties. Larger companies are better able to survive setback in most cases.
Take, for instance, Quebecor Inc., one of our Key stocks. Its acquisition of Vidéotron was largely seen as overpriced. That could have spelled disaster for a company of much lesser size. But for Quebecor, it only meant write-downs that depressed its financial results temporarily.
Price risk is a second sub-category of company-specific risk. That is, a stock becomes riskier the higher its share price rises. This is especially true if it trades at a very high multiple to its expected earnings or far above the book value of its assets. Then any negative shift in investor confidence could send its price plunging.
Predictability risk is a third sub-category of company-specific risk. This includes anything about a company that might affect the reliability or regularity of its revenues, earnings or dividends. Many factors could change any of these, including the types of products a company sells, whether or not it introduces new products, whether or not it prices its products competitively, the stability of its markets, the amount of debt it owes, its susceptibility to lawsuits and so on.
Extraneous risks can be unpredictable
Extraneous risks are also of many kinds. These include natural disasters such as forest fires in British Columbia and the North, the floods that hit Alberta and Ontario, Hurricane Sandy, ice-storms in Eastern Canada, diseases (such as Ebola, among others), terrorism or wars and so on.
Among the more significant of these risks, however, are those of an economic nature. These include economic or industry cycles, changes in interest rates, trade tariffs, currency fluctuations, inflation rates and so on. And, or course, you compound your risk if you buy shares on margin.
Take these steps to reduce your risk
There are things you can do to reduce your risk, however. To lessen asset risk, you can aim high by concentrating your investments in better quality stocks—particularly our Key stocks that we rate ‘Very Conservative’ or ‘Conservative’. You can reduce price risk by becoming more and more cautious about the stocks you buy as prices rise—save boldness for the beginning of a rising trend in prices.
You can reduce predictability risks as well as most extraneous risks by remembering to balance and diversify your portfolio.
Diversify geographically, for instance, and you lessen your exposure to natural disasters. Diversify between, say, utilities and debt-free suppliers of consumer staples and you protect yourself from undue dependence on interest rate levels. Diversify between exporters and companies focused on the domestic economy and you reduce your exposure to trade tariffs and exchange rates. In short, doing this means your success won’t depend too heavily on the fortunes of any one stock or industry group.
This is an edited version of an article that was originally published for subscribers in the September 7, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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