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The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization for registered brokers and firms designed to enforce the rules that it also writes “to safeguard the investing public against fraud and bad practices.” FINRA oversees thousands of firms and hundreds-of-thousands of representatives. When studying to pass FINRA’s numerous licensing exams, there are many topics covered. Of particular interest to me is risk. In this series, I will outline and describe the numerous types of risk FINRA has identified and tests its examinees on.
When thinking about investing, one ought to think about the relationship between risk and reward. Although I will reference stocks, that is merely one arena in which the analysis applies. Indeed the number or arenas in which risk and reward play is numerous as well. The relationship between risk and reward can be discussed in real estate as well. It can be discussed in cryptocurrency. It can be discussed in bonds, et cetera, et cetera. In fact, it transcends investing and reaches wide. It reaches into operations and is present all over: factories, aviation, sports, art and entertainment, military missions, energy, and so on. There are key steps when analyzing risk including identifying risks, mitigating risks, and ultimately the decision to accept the remaining risk (or not). Accepting the remaining risk ought to be weighed against the reward. And the analysis does not stop there even. If one had ten opportunities identified (measured risk ten different times), then which ones do you proceed with? Is it as simple as finding the biggest delta between risk and reward and pursuing that option? Is it as simple as acting on every opportunity where risk-reward falls above an acceptable threshold? What if you have a particular goal in mind such as gaining market share, protecting market share, branding oneself as an innovator, or fighting for a righteous cause? Simply put: the resulting risk-reward analysis is not the end but rather the beginning of decision-making. But without the analysis, you are decision-making blind to the risk-reward spectrum. Decision-making in the dark is unnecessary. Even worse, decision-making with bad information is perilous.
There is an ocean of risk when investing, and each one of the risks is valid in and of itself. Countless investors harness bravery when investing to “overcome” risk. Or they rely on the belief that American companies “are a good bet.” Anecdotally, I happen to agree with both notions. But we can do better than finding the gumption to be brave, we can do better than betting. With a thorough understanding of the risks associated with a company (stock), the investor can identify and mitigate risks too – and not just rely on giant regulatory bodies to paint with a broad brush that may not protect you personally. In the end, regardless of regulation, you are not personally a macro-economic item. While you do care about the system as a whole (that’s a risk outlined below for certain!) you also care about your particular investments – one by one – as what happens to *your* portfolio is most significant to you. As an analogy, buying a house “because home prices go up” is not good enough – all that matters to you is what happens to *your* home’s value!
If individual investors are well informed with quality, usable risk information, then the system as a whole is better! If the individual parts of a complex system are in good shape, then the system can be in good shape, and in turn that individual part continues to be in good shape. It is certainly a virtuous cycle to have individual investors wise about risk. This does not change the fundamental bit that on any one trade someone is the buyer and someone is the seller. I believe too much is made of that moment in time – the presentation that at that moment somebody wins or loses based on the price of the stock in a day, week, year, or decades from now is too bold. In fact, if one is up 25% and sells to a buyer who then goes up 25% too both parties to that transaction won comprehensively. I do not mean to oversimplify these transactions, or to present a notion that everyone can “win” all the time. Moreso, one’s ability to do well in the stock market is about understanding.
If an investor increases their level of understanding, then they have the ability to invest more fruitfully. There are a lot of aspects to investing that require understanding, such as understanding fundamentals, understanding technicals, or understanding sentiment. Each of these is indeed a pillar upon which company stocks are built. But what is the integrity – what is the risk – existing within those pillars?
Risk fracks. And the more risk one buys when investing in a company the more fracking is going to occur within that investment (within that company).
Risk in and of itself does not reward as today’s startup-crazy market seemingly wants investors to believe. It is fair to say however that risk is inherent in frontiers. The companies, start-up or otherwise, that succeed do so while constantly measuring and assessing risk-reward. They identify, mitigate, and ultimately decide if they will accept the risk associated with a decision, so they can in turn be rewarded.
Without further ado, here is a long list of investing risk. In articles to follow, I will dive into detail about each of the following risks:
Asset Allocation Risk.
Maturity Horizons Risk.
Market Risk (Systemic Risk).
Mutual Fund NAV Risk.
Currency Exchange Risk.
Insider Trading Risk.
To be clear, these risks do not deter me! I invest nonetheless and have been successful investing. Just like understanding income statements, balance sheets, statements of cash flows, and so on I dive into risk. It gets a lot of diligence from me. Furthermore, I do not need 1000 stocks. That is at least ten-fold more than investors need.
America does indeed have an army of good companies to choose from. But how do you know which ones are the good ones? Then, from the good ones how do you choose which ones you will buy? I think risk is a big part of that decision.
More from this series on investing risk to follow… and I’m excited to share it with you!
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