So you have learned the importance of investing. It is the most important ingredient in creating financial freedom, but there are some dangers involved. Some investments may even feel like gambling. So how can you avoid risk involved in investing?
You can’t eliminate the dangers, but you can avoid risk in investing by specializing in a particular type of investment, diversifying within that specialty, insuring against accidents, structuring ownership properly and conversing with other knowledgeable investors.
If you do these things, you’ll be able to weather the bad times and explode during the good times.
Know Your Risks
Again, you can’t eliminate risk in life, and certainly not in investing. I wrote an article about the sources of risk in investing, and even the investments that are supposedly “safe,” like U.S. Treasury bonds come with risks.
Here’s my high level list of risks that an investment can have:
- Inflation risk – when the money you’ve invested grows more slowly than the rate of inflation
- Debt risk – assuming debt to invest increases your expenses and so puts more pressure on your investment to perform well
- Legal risk – breaking laws can of course lose you money, but laws changing can also be a huge risk for some investments
- Tax risk – investments are all taxed differently and some provide tax benefits, while others do not
- Ignorance risk – all investors are at risk for what they don’t know and can’t foresee
- Timing risk – the success of your investments can be heavily influenced by when you buy them
- Holding risk – some investments hold your money hostage and only allow it to be accessed at certain times without penalty
It’s good to come back to this list anytime you’re reviewing your own portfolio or looking at a new investment.
Generally, the traditionally “safe” investments have inflation risk, holding risk and timing risk. They can also have tax risk depending on your situation.
And the traditionally “risky” investments will have debt, legal, ignorance and timing risk, potentially with some others as well.
In my opinion, education is the best way to limit your risk with any investment, and that starts with understanding the specific risks associated with your investments.
Strategies To Minimize Risk
By now you should understand that you can’t eliminate risk in investing, just like you can’t eliminate risk in walking your dog or swimming in the ocean. Risk is simply a part of life.
However, with a proper education and understanding of our investments, we can take actions to minimize our risks.
Diversification is thrown around in the world of investing with little specificity. It’s easy to assume that diversifying means buying up as many different kinds of investments as possible. That’s not how I diversify.
I like to pinpoint the biggest risks in my investment portfolio and then invest in new things that shouldn’t be affected by those risks.
To diversify well, you need to understand the risks of your investments, and keep those risks isolated only to a segment of your portfolio. Here’s an example:
Diversifying real estate investments
Right now, Kate and I have three properties listed on short term rental sites (Airbnb and VRBO). All three properties are in the same city and subject to the same city ordinances.
I see two big risks with these three investments:
- The short term rental market slows down or disappears
- The local ordinances in my city change, hurting my investments
So I see two main ways to diversify here:
- Purchase long term rentals, since they won’t be affected by the ups and downs of the short term rental market.
- Purchase short term rentals in another city, so those will not be affected by the ordinances in my city.
Sure, I could buy some stock or something, and depending on the stock, I could diversify effectively. The problem is I don’t know very much about investing in stocks, so I would open myself up to ignorance risks.
Really, the point I’m trying to make here is that you can have a diversified investment portfolio that consists entirely of real estate. As long as your entire portfolio doesn’t share the same risk, you have diversified effectively.
This is a risk avoidance technique I don’t see mentioned very often. Specializing in one or two types of investing allows you to become extremely knowledgeable about your investments.
If your diversification strategy is to own some stock, and buy some gold bullion, and then maybe get one long term rental and one short term rental, then buy a business, you’re going to stretch yourself too thin. There’s no way to know everything about everything, so you’ll open yourself up to a lot of risk simply by being ignorant of various parts of your investments.
If you stick to one type of investing, then your past experiences will create a natural protection around your future investments. Your past mistakes become future successes.
To revisit the real estate example, I can have a well diversified investment portfolio consisting only of real estate. And since I become more knowledgeable about real estate investing over time, I’ll have virtually no ignorance risk after 5-10 years.
Some investments require insurance, and some don’t. If you own stock in a company, then you probably couldn’t get insurance on that investment even if you wanted to. But if you own a business with employees that operate heavy machinery, then you probably want some insurance that helps protect you against one of your employees getting injured.
Knowing your risks is important here as well, but sometimes it’s best to ask a professional for advice on insuring your investments.
Don’t ask insurance providers, though! They just want to sell you as much insurance as they can. Usually, you’ll want to ask a lawyer. It’s a lawyers job to protect you against lawful action, not sell you insurance. Depending on what type of investment you’re insuring you may also want to talk to an accountant, a realtor and other investors.
Kate and I started a mastermind group about a year ago. It’s just a small group of people who invest, and we get together to talk about strategies and get feedback on the investments we’re looking at.
I’ve used other group members to help with my due diligence and point out risks I hadn’t seen. They have also had ideas for reducing my risks that I hadn’t thought of.
Overall, I just think it’s a great idea to have a group of trusted confidantes that you can brainstorm with and bounce your ideas off of.
Business structure (LLCs and corporations)
In some cases, you can also structure your investment ownership in a way that isolates your risks to a business entity.
For example, if you own an LLC and that LLC owns a business, then if the business goes under, you’re personal assets (like your house, personal bank accounts and retirement funds) may still be safe.
Simply owning an LLC that owns your investments isn’t always enough to protect your personal assets. You’ll want to consult professionals like a lawyer and an account to create an ownership structure that shelters you from risk.
My Strategy For Risk Avoidance
Before I finish up, I want to give a brief overview of my personal strategy for avoiding risk in investing.
First, Kate and I are specializing in short term real estate and content based online business. We currently have one long term rental that has done well for us. However, we don’t want to specialize in long term rentals, so we will eventually sell that property and exchange it (tax deferred) for a short term rental.
Second, we are starting to diversify our real estate by looking to buy outside our home town. This should help us mitigate the risks associated with local ordinances affecting short term rentals.
Third, we are working towards a business structure that removes our personal property from risk. It is much easier to get financing by purchasing assets in your own name, but this puts your personal property at risk. We will slowly move our investments into our LLC to separate our personal assets from those risks.
Fourth, we are constantly learning. We have a mastermind group that keeps us talking with other investors and we try to always have an investment related book on our nightstand. The more we know, the less likely we are to make avoidable mistakes.
Risk is a part of life and a part of investing. That doesn’t mean we have no control over it.
By taking educated steps like specializing and diversifying (not an oxymoron), and using professionals to help isolate our risks, we can feel safer purchasing high yielding investments like business and real estate.