The Oxford Language Dictionary defines risk management as “the forecasting and evaluation of financial risks together with the identification of procedures to avoid or minimize their impact." That makes sense; investors routinely incorporate risk management into their decision-making process. Part of the task involves determining how much risk is acceptable (risk tolerance) since some people are willing to risk more in pursuit of a greater potential reward.
How do I assess my risk tolerance?
Risk tolerance measures how much risk you are willing to take and how much you may fear loss. Risk capacity is similar to risk tolerance but is a more tangible measurement since it evaluates how much risk you can take—how deep is your resource pool. For example, an investor may have significant resources, indicating an excellent risk capacity, but if that person abhors the thought of losing capital, they may have a lower risk tolerance.
How do I manage risk?
The first crucial step in managing risk is identifying it. Investments are risky, with the possible exception of Treasury bonds. Whether you invest in stocks, corporate bonds, or real estate, you could lose your capital—the money you invested. Investors accept this risk in return for the potential reward of earning a profit through income or appreciation.
One way to manage risk is through diversification. If investors spread their investment capital across various asset types, they can reduce the risk of overall losses. For example, suppose that you have $100,000 to invest. You might divide it up to mitigate the risk by putting some into stocks, some into bonds or cash equivalents, and some into real estate. Your securities may have a higher risk along with the opportunity for higher potential gains. Your bonds may have less risk and less potential reward. Real estate risks and returns vary across the risk spectrum depending on the type of asset.
However, you are exercising risk management simply by investing in more than one asset. The chances that the stock, bond, and real estate investments will all experience substantial losses are less likely than any individual category encountering that result at a given time.
What is a good diversification strategy?
Allocating your investment dollars between various asset classes can be macro or micro. For example, stocks, bonds, and real estate are different asset types. However, you can further define stock investments to include large and small capitalization options and spread your portfolio out to include various industries.
Some investors prefer to invest through a mutual fund that offers automatic diversification by owning a wide range of stocks. Index funds can achieve significant diversification by holding companies that return a mirror performance of the targeted index.
Similarly, with real estate, investors can include more than one sector in their portfolio, such as multifamily housing, office, industrial, and hospitality. Furthermore, real estate investors can choose fractional commercial real estate ownership by investing in a Real Estate Investment Trust (REIT) instead of purchasing specific properties.
No matter what approach you take to managing risk, it's essential to be comfortable with the level of risk you are incorporating into your investment strategy. Your risk appetite may be greater or smaller than someone else's, but your comfort zone is what matters.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Risk tolerance is an investor’s general ability to withstand risk inherent in investing. There is no
guarantee a recommended portfolio will accurately reflect your tolerance to risk.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
There is no guarantee that the investment objectives of any program will be achieved.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
