7 Strategies to Lower Investment Risk While Creating Wealth
Every investment carries some level of risk, which makes it crucial to approach all your investment decisions with cautiousness. Excessive risk can lead to significant financial losses, while being overly conservative with your money can result in potentially lower returns. The only way out is by striking a balance between risk and reward. While it is impossible to eliminate risk, employing the right strategies can help you manage and mitigate it.
Your portfolio’s risk should align with your individual risk tolerance. A financial advisor can help you understand how to reduce investment risk based on your personal situation and preference. Additionally, this article will explore seven strategies designed to help mitigate risk while investing your money.
Table of Contents
Below are seven ways on how to reduce investment risk:
1. Diversify your investment portfolio and distribute your capital across multiple asset classes
Diversification is one of the most effective strategies for managing investment risk. It essentially refers to investing in multiple asset classes to reduce the likelihood of significant losses. Since different assets often perform differently under varying market conditions, your portfolio’s overall performance is maintained. If one asset underperforms, others compensate for its loss and help you balance your returns over time.
How can I diversify my investment portfolio to reduce risk? You can consider the following key points:
- Avoid over-diversification: While diversification is beneficial, spreading your investments across too many assets can lead to higher costs and complicate your portfolio without offering any real benefits. Over-diversifying may also negatively impact your potential returns and expose you to more risks due to the lack of focus on quality assets. Therefore, it is essential to find a balance where your investment portfolio has a mix of suitable assets without creating unnecessary complexity.
- Explore beyond traditional asset classes: While stocks, bonds, and cash are foundational components of an investment portfolio, there are many other investment avenues for you to consider. For instance, real estate provides exposure to property markets. You can invest in it directly or through Real Estate Investment Trusts (REITs). Cryptocurrencies also offer a unique risk-return profile and expose you to a different type of market altogether. Commodities like gold and others can also provide hedging against inflation and stock market ups and downs. You can consider adding these diverse instruments to truly gain from diversification.
- Diversify within asset classes: You must also understand the importance of diversification within each asset class. For instance, if you are investing in stocks, you can invest in companies across various industries and sectors within the stock market and consider different market capitalizations, such as large-cap, mid-cap, and small-cap stocks. Similarly, if you are investing in the bond market, you can diversify among government bonds, municipal bonds, corporate bonds, and Treasury Inflation-Protected Securities (TIPS) to manage risk.
While diversification does not guarantee high returns, it does help you enhance the stability of your portfolio. However, you must use it tactfully to maintain an effective investment strategy.
2. Consider hedging to lower the risk
Hedging is an investment strategy that involves investing in uncorrelated assets to mitigate potential losses. Uncorrelated assets are those that do not have a relationship with each other’s returns. Their values move independently in response to different market fluctuations. Hence, when you include such assets in your portfolio, you are able to effectively reduce overall risk because the poor performance of one asset class is counterbalanced by the positive performance of another.
A classic example of hedging is using a combination of stocks and gold. Historically, gold has been an effective hedge against stock market downturns. When stock prices fall, gold prices often rise. This allows you to offset the losses incurred from equity investments and stabilize your portfolio during volatile periods. Another common hedging strategy is to combine stocks with bonds, such as the U.S. Treasury bonds. Treasury bonds are considered low-risk investments and have often performed well during periods of underperformance. Moreover, most investors typically move their funds into safer assets like Treasury bonds during market downturns to safeguard their portfolios. This positively impacts their value at a time when the stock market is experiencing a downturn.
You can consider the following tips to effectively implement a hedging strategy:
- Select truly uncorrelated assets: You must ensure that the assets you choose have little to no correlation with each other. Picking assets that are closely correlated will not have the same effect on your portfolio. You can take advice from a financial advisor on the same.
- Monitor your hedging strategy regularly: It is essential to review your portfolio regularly. Regular reviews ensure that your risk management strategy remains aligned with your financial needs. It also allows you to monitor how your assets are performing in response to different market conditions and make changes to your strategy, if needed.
- Understand the costs: Just like diversification, hedging can also involve costs, depending on the kind of assets you invest in. You must keep these costs in mind to ensure your returns are not compromised.
3. Maintain a long-term investment strategy to ride out market fluctuations
Adopting a long-term investment strategy is a powerful way to counter market volatility and build wealth over time. If you analyze historical data, you will find that the stock market has typically shown an upward trajectory over the long term, despite short-term fluctuations. While market downturns are inevitable, and you are likely to experience them every now and then, they are typically always followed by recoveries. So, while your investments may show losses in between, as long as you hold on, these assets will likely bounce back.
A key advantage of long-term investing is the benefit of compounding. The longer your money remains invested in a particular instrument, the more time and opportunities it has to grow through compound interest. Compound interest is the interest that is generated on your returns when they are reinvested in the market. Over time, this can lead to higher and faster growth. Long-term investing also involves less frequent trading and fewer decisions on your part, which can reduce the associated costs as well as the likelihood of making errors. Instead of reacting to short-term market movements or attempting to time the market, a long-term approach focuses on doing nothing and allowing your investments to grow on their own. This strategy also minimizes emotional decision-making.
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4. Increase the allocation to cash in your portfolio
Cash is one of the main asset classes in a diversified portfolio. In the context of investing, cash refers to highly liquid assets, such as money market funds or short-term debt instruments. These are cash-equivalent investments designed to help you maintain liquidity while creating a buffer against market volatility. It can be helpful to reserve a portion of your investment portfolio for cash or cash equivalents if you are looking to lower risk. This can offer you several advantages, particularly during periods of market instability.
When the stock market falls, you have the opportunity to buy low-priced stocks and potentially earn more later if you sell them when prices bounce back. At such a time, the concept of buying low and selling high can be effectively applied to make a profit in the future. Having enough cash available to purchase the stocks of your choice can be a boon and help you make timely decisions. Typically, panic sets in when the market experiences a downturn, and investors start selling off their holdings to curtail their losses. Asset prices drop, and many investments become available at reduced prices. Maintaining a cash reserve helps you acquire these assets at a discount and potentially benefit in the future.
The appropriate amount of cash in your portfolio generally depends on your age, risk tolerance, and financial goals. For example, a higher cash allocation may be prudent for retirees with a low-risk tolerance. Maintaining a significant portion of your net worth in cash or cash equivalents can help you preserve capital and provide liquidity in retirement. It also reduces exposure to market volatility. Older investors can allocate up to 20% or more of their portfolio to cash to safeguard their investments and ensure they have funds available for immediate needs. Younger investors, such as those in their 30s with a longer time horizon and higher risk tolerance, may prefer to keep a lower proportion of their portfolio in cash. With a longer investment horizon, younger investors have a relatively higher risk appetite and may benefit more from investing in more aggressive investments with a focus on wealth creation. You can maintain a smaller cash allocation of around 10% when you are young. This can be helpful to address any liquidity concerns and lower overall portfolio risk while helping you focus on your larger goals.
It is also important to consider the potential downside of holding excessive cash, no matter your age and risk appetite. Cash and cash equivalents generally offer lower returns compared to other investments and may not keep pace with inflation. Therefore, you must balance your cash allocation with growth investments to take advantage of market opportunities.
5. Invest in blue-chip, large-cap stocks
If you are concerned about how to reduce risk in investment, you can give blue chip stocks a try. Blue-chip, large-cap stocks are shares of well-established companies with a strong financial foundation and a history of financial stability. These companies are usually well-established brands in their respective industries. As a result, they are relatively better equipped to come out of a market downturn compared to smaller, less established firms.
Investing in blue-chip stocks can help you reduce investment risk while aiming for steady returns. One of the primary advantages of blue-chip stocks is their stability. Due to their established name and reputation, these companies are less likely to experience significant declines during market downturns. Even if your stock holdings from such companies experience lows, these are mostly temporary and likely to be mitigated as the market stabilizes. Moreover, blue-chip stocks have the potential to provide steady dividends. Many of these companies pay regular dividends, which helps you earn a regular stream of income and enhance your portfolio’s productivity.
However, there are some important considerations to keep in mind when investing in blue-chip stocks. Despite their stability, it is crucial to maintain diversification within your portfolio. When investing in blue-chip stocks, you must aim to include established companies from various sectors. Moreover, do not invest solely in blue-chip stocks, as this may expose you to higher risks. Instead, balance your investments across various asset classes to manage risk more effectively and ensure a stronger investment strategy.
Additionally, you must understand that investing in blue-chip stocks may lead to potentially lower returns. While these stocks offer safety and stability, their growth potential might be limited compared to smaller companies. Blue-chip companies are typically already well-established, with little scope to grow further. Therefore, it is essential to balance blue-chip investments with other assets that offer greater growth potential to achieve a well-rounded portfolio.
6. Invest in high-quality bonds to lower risk
Bonds can be a relatively safer investment compared to stocks, but they still come with their own set of risks. Two primary risks associated with bonds are interest rate risk and default risk. Understanding these risks and investing in high-quality bonds is important to lower risk and eliminate potential losses.
There is an inverse relationship between bond prices and interest rates. When interest rates rise, the value of bonds typically falls. Conversely, when interest rates decline, the prices of existing bonds generally increase. While you cannot control changes in the interest rate, you can manage this risk by investing in bonds with shorter durations.
The second risk that you may encounter when investing in bonds is the default risk. Bonds are issued by bond issuers, and there is a possibility that the bond issuer will default. If the issuer defaults, you can lose your capital as well as any profits earned on your capital. To reduce default risk, you must invest in bonds from reputable issuers. You can consider government bonds, such as U.S. Treasury bonds, as they are backed by the government and offer more stability and assurance. Additionally, you can check the credit ratings allotted by agencies like Moody’s, Fitch, and Standard & Poor’s. Bonds with higher credit ratings, such as AAA or AA, indicate lower default risk and can be added to manage risk more successfully.
7. Educate yourself and research well before investing your money
Educating yourself is an effective way to reduce investment risk. The more knowledge you have, the better equipped you are to make informed decisions. Relying on data and rational analysis can enhance your investment strategy and improve your chances of success. Education helps you grasp how different assets function and how market conditions can affect their performance. With the right knowledge, you can more accurately align your investment choices with your financial goals and risk tolerance. Understanding the market and educating yourself allows you to better comprehend your own risk appetite and financial goals. This is essential for selecting suitable investments that match your risk preference and your long-term financial aspirations.
Furthermore, thorough research before committing your money can help you avoid common errors and make more informed choices. It is crucial to steer clear of fear-driven choices and base your investment decisions on published data, historical research, and factual evidence.
To conclude
Investment risk is not all that bad. It can be a valuable part of the investment process. Taking on risk allows you to pursue potentially higher returns, but finding the right balance is crucial. It is important to invest in a manner that aligns with your risk appetite and financial goals to ensure that you maintain a balanced approach throughout your investment journey. Understanding your own risk tolerance and financial objectives will help you make informed decisions. However, consulting with a financial advisor can be highly beneficial if you find yourself unsure about your investment choices. A financial advisor can help you adopt the right approach and avoid downsides that could jeopardize your financial well-being.
Use the free advisor match tool to get matched with experienced financial advisors who can help you create a balanced portfolio and lower your investment risk. Answer some simple questions about your financial needs and get matched with 2 to 3 advisors who can best fulfill your financial requirements.
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