Limited Risk

What Is Limited Risk?

The term-limited risk refers to an investment strategy that caps the potential amount of loss an investor can face — usually, the initial amount invested. This means the investor knows how much they could lose in the event market conditions go south.

Investors who employ this strategy do so by purchasing securities that move in opposite directions. This strategy basically provides investors with a form of insurance or protection against possible losses.

How Limited Risk Works

Limited risk refers to placing an investor in situations where they are aware of the maximum level of loss they may be exposed to before they even enter into a position. This type of strategy puts a ceiling on the potential loss, helping protect a portfolio against any volatility in the market. It can be especially attractive when an investor has experienced an extended period of gains and wants to lock in some of those positive returns.

One way to achieve limited risk is to buy stocks that are not as sensitive to economic cycles. Sometimes called defensive stocks, they include companies in the food, utilities, or other industries that sell products that consumers consider necessary. These stocks theoretically hold their value during recessions and other economic downturns, which tend to depress the performance of the stock market as well.

Options Strategies

Another way to limit the risk of an equities investment is to purchase a put option contract on the shares. This approach may sometimes be costly, but it allows an investor to lock in a minimum price at which the shares could always be sold. An investor could also sell a futures contract, promising to sell the stock at a set price at a certain point in the future.

As noted above, an investor who chooses a limited-risk investment is fully aware of the potential amount they could lose. For example, entering into a cash long position in a stock has a limited risk because the investor can lose no more than the initial amount invested. Similarly, buying options contracts (which give you the right, but not the obligation, to purchase an asset at a certain price by a certain date) has limited risk. If the asset's price moves against you, and it makes no sense to exercise the option, only the initial premium you paid to buy the option is lost.

Like all investment strategies, limiting one’s risk requires a little planning. However, the security that this strategy provides could make it well worth the time and effort during a period of declining stock prices.

Example of Limited Risk

Let's say an investor creates an investment portfolio that includes shares of the company Cushy Couches, which manufactures luxury sofas and chairs. Since the furniture industry is a cyclical one, Company Beta will likely sell more couches during boom times than it will when the economy is slow or contracting.

Because of this, Company Beta’s shares will decline in value during slow economic times — something that the investor should be aware of when they invest in the company. The investor will probably want to protect their portfolio from this volatility by purchasing an equal amount of shares (or making a comparable investment) in the Super Foodstuffs Corporation — a leading manufacturer of grocery staples, and a venerable defensive stock. As mentioned above, economic downturns don't necessarily affect the value of such firms — everyone's got to eat, after all — so they'll act as a bulwark, limiting the risk of holding shares of Cushy Couches.

Limited vs. Unlimited Risk

Unlimited risk is the opposite of limited risk. It occurs when the potential for losses is not capped. As the name suggests, there is an infinite, or unlimited, potential for losses on a particular investment.

While investors may lose just the value of their initial investment with limited risk, unlimited risk means they can lose much more than that — whether it's just a small portion, or the entire investment itself.

Since no investment is 100% guaranteed, performance-wise, no investor is completely safe from unlimited risk. But especially vulnerable are traders and investors who buy on margin (that is, via loans from their broker) or who partake in short selling — borrowing a security and selling it on the open market, with the aim to buy it back later for less money. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.