It’s another Friday, so you know what that means! Financial Tip Friday is here. This week we’re going to review how to use insurance risk management methods to analyze an investment’s risk. Stock investing can bring great rewards – but those potential rewards always come with risk. The insurance industry is essentially involved in assessing, managing and mitigating risk. It stands to reason, then, that the principles insurance assessors, agents and writers bring to their area of expertise could be applied to stock investment.
The Five Steps
As covered in the article “What is Risk Management,” insurance professionals go through a five-point checklist to effectively manage risk. First, they identify risks or threats. Next, they assess the vulnerability of key assets to that threat. Third, they ascertain the expected outcome of the threat. Fourth, they develop a strategy to eliminate the threat. Finally, they establish procedures to deal with the risk.
Risk and Stock Investment
All investment comes with risk. Weighing the relationship between risk and reward is the most basic essence of what it means to invest – risking a little bit of money in the hopes that shrewd maneuvering will turn it into a lot. With that in mind, the five steps of insurance protocol could just as easily be applied to stock investing. Before any trade is made, or any security is purchased or sold, the investor should think like an insurance professional.
Applying the Five Principles
When investors step into the shoes of insurance risk managers, they should simply apply the five insurance principles to their own trade:
- Identify risk: Before an investor settles on a stock, he or she should look for risks such as excessive debt or financial trouble involving the company’s leadership.
- Assess the vulnerability of key threat assets: Investors can look for weaknesses or vulnerable areas within the threat that could mitigate its potential.
- Ascertain expected consequences: This goes directly to risk/reward – how badly could the threat hurt your investment? In the end, is it worth it?
- Determine risk reduction strategy: This step often comes in the form of portfolio diversification.
- Procedure creation: This step will vary wildly depending on the investment, the temperament of the investor and the amount of acceptable risk. Essentially, it will be an accumulation of the first four elements.
All investors could stand to take cues from the insurance industry. They both deal with risk, and they should both primarily be focused on ways to avoid – or at least mitigate – that risk. Insurance firms provide protection against fires, floods, burglaries, tornadoes, hurricanes, droughts, terrorism – even death. Compared to the pitfalls your investment portfolio faces, there’s no risk you will encounter that insurance companies haven’t dealt with.
Andrew Lisa is a freelance financial writer. He covers the stock market and personal finance.