How to manage investment risk? Investment risk management is an act of using strategies to minimize the prevailing risks associated with all forms of investment.
In today`s world of rapid globalization, there`s no investor that is not familiar with investment risks. Every investment is prone to one form of risk or the other, hence the need for risk management to control investments risk.
6 Tips to Help Manage Investment Risk
Controlling risk is paramount to your investment strategy. One of the ideal ways to manage risk is to spread your investments and savings across a number of channels.
This is crucial because if you have all; even most, of your money in one place (be it real estate, the stock market or even municipal bonds issued by your hometown), you`re at a greater risk to lose it all should anything goes wrong.
There are basically three main ways to control risk. They include diversification, investing consistently and investing over a long period of time.
Manage Investment Risk by Diversification
A well-balanced investment portfolio entails spreading investment funds across different types of assets and investing in various securities within each type of asset. This minimizes risk because there is a probability one or more investments might falter, the rest will gain.
When you think about that, it`s sensible that diversification among types of assets helps reduce risk.
Diversifying simply means spreading investments across various industries or sectors (e.g., Health care and technology) and securities (e.g., bonds and stocks), and using different investment products to protect the value of your overall portfolio in case a single security or market sector suffers a serious setback.
Look at it this way: If all of your money was in a single company`s stock and that stock unexpectedly plummeted 50%, You would suffer a loss of half of your savings.
But if your investments were spread out across several stocks, as well as bonds, real estate and other products, then the loss won`t affect you that much.
Manage Investment Risk by Investing Consistently
One sure way to make the most of investments for a long time is to commit to investing a specific amount on a regular basis. For instance, let`s assume you are going to invest $100 in company XYZs stock every month.
The value of the stock will experience fluctuation from month to month based on the company`s performance and the demand for the stock, including other factors. Irrespective of whether the stock is high or low, you purchase as many shares of company XYZ`s stock as you can with your $100.
The first month, your $100 could buy you two shares, the following month it might buy only one share. However, regardless of the situation, you consistently invest your $100. This is called currency-cost averaging.
Currency-cost averaging means you invest a certain amount of money at a regular time interval (e.g., bi-weekly or monthly), irrespective of what the market is doing.
At times you`ll purchase high and other times you`ll buy low, however since markets generally rise with time, you`ll always do well over the long term. Let`s consider another example. Assuming you have $30 to invest every month:
Over the span of complete six months, you were able to purchase shares at a better price than the average. But six months is not long enough to see tangible returns on stock market investments.
To see real benefits of currency-cost averaging, you would at least hold your investments for 10 years. That`s why it`s vital to view investing in the stock market as a wealth-building tool and long-term savings, and not a get-rich-quick tactic.
The key to currency-cost averaging is to choose carefully which companies to invest in. This approach is particularly best for purchasing stock in industries or companies that you expect to have consistent growth over time, instead of risky startup companies – except you`re willing to take on higher risk.
Manage Investment Risk by Investing over time
Research reveals that investing for the long term minimizes investment risk because, even though the price of a particular investment may rise and fall within a short period of time, it generally will recover any losses over the long term. Investing is clearly a long-term strategy for long-term goals (ideally 5,10, 20 year or longer).
Withstanding short-term price fluctuations usually generates greater long-term benefits for stocks compared to other asset classes. Stocks fluctuate greatly in value more than CDs, that you can lose part or even all of your investment in a short time. However, over long-term, stocks, on average, substantially and consistently outperform cash and thief of cash; that is, inflation.
Manage Investment Risk by Position Sizing
To play defence is to simply reduce your exposure. If a particular investment is riskier than others, you can simply choose not to invest in it or to put in only a small amount of capital. Most investors usually use this type of approach to gain exposure to riskier sectors, such as biotechnology or small-cap stocks.
For example, a 50% loss on a $2,000 investment hurts a lot less than it would on $15,000 investment. The simplest way to lower your stock market risk is to move some of your capital to cash.
Manage Investment Risk by Always Putting a Stop Loss Order
You can simply place a stop-loss order with your broker that will automatically sell out part or all of your position in a given stock if it falls less than the preset price point. Basically, the trick is to set the priceless that you won`t get stopped out on a routine pullback, however high enough that you will limit your capital loss.
Placing a stop-loss order is a way of limiting the damage to your portfolio and forces yourself to adhere strictly to defensive discipline. Shifting of ignoring stop-loss levels almost usually results in greater losses in the end. The first exit is always a wise step.
Manage Investment Risk by Rebalancing
Long term investors could try as much as possible to manage risk by periodically selling asset classes or investments that have come to take up too much of their portfolios. They will sell off those assets or investments and buy more of the stocks that have recorded less performance. This can be a forced means of buying much lower and selling high.
Joseph is an author who likes to contribute to a variety of blogs. Joseph is married with one beautiful daughter. He lives with his family and writes to inspire productive life and financial freedom. And above all, he is a promoter and a champion of human well being.