General risk management strategies
There are different types of risk control strategies. They include:
- Avoidance: Depending on the threat, it may be an option to avoid activities that increase the likelihood of threat occurrence. A company might exit a geography, for example, to avoid geopolitical risk in that region.
- Reduction: Reduction involves taking steps to minimize potential losses associated with a risk. Southwest Airlines (LUV -1.65%) regularly uses fuel hedges to protect itself against fuel price spikes.
- Transfer: Businesses and individuals regularly transfer the risk of financial loss by purchasing insurance.
- Acceptance: Every business, individual, and household has thresholds for risk, but there is always some level of risk that is acceptable and unavoidable. For example, you lower the risk of getting laid off, but you can't eliminate it without accepting unemployment or starting your own business.
These strategies are not mutually exclusive. One risk may require two or more responses. For example, some level of risk acceptance will be required when it is impossible to eliminate all risk through avoidance, reduction, or transfer.
Managing investment risk
Managing investment risk is its own discipline, but it follows the principles and steps described above. On a granular level, many investors will do a comprehensive business risk assessment prior to making a trade. If you are considering buying shares of Apple (AAPL +0.11%), for example, you might review legal issues, disappointing sales trends, or lack of new product launches as potential threats.
You could then choose to avoid, reduce, transfer, or accept the risk you've identified:
- To avoid the risk, you would not buy Apple.
- To reduce risk, you might diversify, limit your investment in the company, or commit to a long holding period so you're not affected by immediate-term volatility.
- To transfer the risk, you could buy a protective put option that gives you the right to sell Apple at a set price within a certain time.
- To accept the risk as is, you would buy Apple shares without any mitigation strategy.
