The 6 Key Strategies for Managing Investment Risks

A high-risk investment strategy may bring you the prospect of high returns, but it also comes with more volatility and a fair share of stress. Without the right safeguards, these risks can threaten your peace of mind and potentially lead to portfolio losses. That is why it is crucial to have the right strategies in place to protect your investments. There are several different investment risk mitigation strategies to choose from. You can discuss these with your financial advisor and implement the one suited to your investments.

This article will also dive into some effective investment risk management strategies to manage portfolio risk so you can make more confident decisions.

Below are 6 strategies to help reduce investment risk:

1. Diversify your portfolio with the right assets

The first rule in the handbook for reducing investment risk is to diversify your investment portfolio. A diversified portfolio ensures that your money is invested in a number of different investment options. This ensures that you are not dependent on a single investment for generating returns. Even in the worst-case scenario, if some of your investments do not do well, others will, and you will be able to earn some returns while your other investments recoup from the losses.

However, how do you diversify your portfolio? Diversification, though simple in theory, requires balance to be effective. The first step is diversifying within each type of asset. If you are investing in stocks, consider creating a mix across different market capitalizations, such as large-cap, mid-cap, and small-cap stocks. In addition, it is also important to diversify across sectors. You can include sectors like consumer goods, healthcare, energy, and finance, among others, to increase your chances of having steady performance. In contrast, if you invest in only a single sector, you risk losing your money in case of a downturn. This can happen even if you choose different companies within the same sector. Different sectors react differently to economic shifts. For example, consumer goods held up better during the 2020 COVID-19 pandemic than some other sectors like automobiles. If you had invested only in automobile stocks, you would have lost money, but if your portfolio had a mix of different sectors, you would have balanced out the losses with some gains. Global diversification is also important. You must invest in American stocks as well as other markets, such as Europe or Asia, among others, to ensure you are less exposed to the political and economic uncertainties of a single country.

Apart from diversification within a single asset class, you must also aim to invest in different asset classes. So, if you are investing in stocks, you must also consider adding other assets, such as bonds, to your portfolio. While stocks tend to offer high returns, they also come with high risks. Bonds, on the other hand, are relatively stable with predictable returns. You can diversify into bonds to earn steady returns, even when your stocks are not performing well. However, even with bonds, diversification is crucial. Municipal, corporate, and government bonds each have different risk and return profiles. Government bonds are often the safest but offer lower returns, while corporate bonds may offer higher returns but come with greater risks. Municipal bonds can be tax efficient. Your portfolio should maintain a suitable mix of all these for better returns and lower risk.

2. Invest consistently to benefit from dollar-cost averaging

There are different types of risk associated with investing. One of these risks is known as timing risk. The market is never stable. It moves up and down every now and then. Investors are always trying to time the market in the pursuit of finding the golden moment when the market will fetch the highest returns. However, there is no such thing. Timing the market is next to impossible, and it is rare to get this right. Instead, investing consistently over time is a more reliable and proven strategy. This helps you benefit from dollar cost averaging and develop a healthy habit of investing regularly.  Dollar-cost averaging is a strategy where you invest a said amount of money into a particular asset at regular intervals, such as weekly, monthly, quarterly, or annually. You are required to do this regularly, regardless of market prices. For example, instead of investing a large sum of money in a stock in one go, you can set aside a fixed amount each month. This allows you to purchase more shares when prices are low and fewer when prices are high, which effectively reduces the average cost per stock over time. Dollar-cost averaging can be most commonly seen in employer-sponsored retirement plans like 401(k) or other retirement plans like the Individual Retirement Account (IRA), where you contribute a portion of your paycheck regularly. These contributions are made irrespective of the price of shares at the time. This automated approach removes the decision-making process and eliminates the pressure to buy a stock at only the perceived right moment. It also frees you from emotional reactions that often lead to impulsive decisions. With consistent investments, you remove the need to make impulsive decisions and, instead, follow an objective and unbiased process that focuses on your long-term goals.

Consistent investing also allows you to achieve your goals slowly but steadily. It allows you to benefit from the power of compounding and gain immunity from short-term market fluctuations. Irrespective of whether the market rises or dips, a fixed investment amount is put into the market. You may buy more shares when the prices fall and less when prices rise, but over time, this disciplined approach assures returns and prevents emotional reactions.

3. Use the asymmetric risk investment strategy

The common belief is that taking huge risks is the only way to secure a big profit. However, this is not always true. In fact, you can also do the opposite. Rather than taking significant risks, you can look for opportunities with high potential returns and limited downside risk. This strategy is called asymmetric risk-reward. This approach focuses on maximizing your potential gains while minimizing potential losses. It contrasts with traditional high-risk, high-reward investment approaches, where investors look for instruments that carry high risk for the potential for a high reward. The asymmetric risk investment strategy looks for scenarios where the potential reward is far more than the potential risk. So, even if only a portion of your investments succeed, the returns can still offset any losses you may have incurred.

For instance, consider an example where you find a stock that is expected to appreciate significantly in the future. This could be due to a new product launch or positive news about the company. Either way, you feel confident in the stock’s future potential and invest in it. Following the principles of the asymmetric risk investment strategy, rather than investing vast amounts of capital outright, you use leverage. This allows you to control a more considerable position with a smaller upfront investment. Suppose the leverage is 1:100. In this case, for every dollar invested, you will be able to control $100 worth of the assets. So, by investing $1,000 with 1:100 leverage, you can control $100,000 worth of the stock. The leveraged position can yield a significant gain if the price rises even a tiny amount. However, leverage also amplifies losses if the price moves in the opposite direction. However, to protect against substantial losses, you can use asymmetric risk strategies, such as setting a stop-loss order. A stop-loss order is a predefined price level at which the trade is automatically closed to prevent further losses. For instance, a stop-loss set to limit losses to 5% would mean you are only risking $50 for every $1,000 invested. Ideally, the stop-loss level should be set at a point where you are comfortable with the potential loss. This way, you can chase high returns while also protecting against steep losses.

It is important to note that though the asymmetric risk strategy seems attractive, it can be complex and requires a deep understanding of risk management and the market. Therefore, it is generally only advisable for experienced investors or those working with financial advisors. Without the required expertise, the strategy can quickly backfire and lead to more risk.

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4. Move to low-volatility options like bonds

While it is advised to keep your investment portfolio diversified, you can add more bonds to your investment mix if risk is a concern for you. A 70:30 ratio between bonds and stocks, for instance, can reduce overall portfolio volatility. Bonds are essentially loans that you give to the issuing entity, such as the government, a corporation, or a municipality. In return, the issuing authority gives you interest payments regularly. The money you lend can be used for various projects and operations. And when the bond matures, the entities pass on their profits to you as interest payments. Bonds offer reliable and predictable returns. They are less exposed to market fluctuations than stocks and are typically used near retirement. Having said that, you can also invest in them if you are not nearing retirement and simply prefer steady returns over high-risk, high-reward investments. Another reason that investing in bonds is one of the best investment risk management strategies is that they have an inverse relationship with stocks. Typically, whenever the stock markets fall, bond markets usually perform better and help stabilize your returns.

It is essential to recognize that the risk and return potential of a bond can vary significantly depending on the issuer. Government bonds are considered to have the least amount of risk as they are backed by the government and offer a high level of security with little to no risk of default. However, they may also offer lower returns compared to others. Municipal bonds are issued by state or local governments and are relatively low risk. They offer similar returns with an additional benefit of tax savings, as the interest earned on these bonds is generally tax-exempt at the federal and, in some cases, state level. Lastly, corporate bonds are issued by private companies to raise capital. They tend to offer relatively higher returns but also carry a higher level of risk.

5. Use alternative investment strategies and risk management

You can use alternative investment risk mitigation strategies like investing in real estate, cryptocurrencies, etc. These allow you to diversify your portfolio beyond traditional assets and potentially offer higher returns. These investments do not correlate as closely with the stock market, which makes them a useful tool for reducing portfolio volatility.

Real estate, especially in the commercial sector, can offer a reliable income stream through rental yields and capital appreciation over time. Even when stock markets are volatile, real estate values may remain steady, providing you with consistent returns. They do not move in sync with traditional assets like stocks and bonds. On the other hand, cryptocurrencies are highly volatile but have shown the potential for high returns. Moreover, they are not correlated to the stock market and do not react to political, legislative, and other factors like fiat currencies. They can be added to the portfolio for better diversification, which, in turn, can lower the portfolio’s overall risk.

However, while alternative investments can help you lower risk, you must know how to use them correctly to ensure you get the desired results. For instance, it is essential to allocate only a small percentage of your portfolio to alternative investments, such as 5% to 20%. Anything higher than this may add more volatility. Moreover, investing in alternative investments, such as cryptocurrencies, requires research and experience. The same can be said for real estate as well, especially given the high investment values. You must research the location, type of property, rental prospects, maintenance costs, property taxes, and more before arriving at a decision.

6. Consult a financial professional

Risk is a subjective concept. What feels risky to one person may seem conservative to another. That is why investment risk management strategies work best when they are tailored to each person’s unique financial situation and goals. For instance, some investors may view alternative assets like cryptocurrency as a smart way to diversify if they allocate just a small portion of their portfolio to it. For others, cryptocurrency might feel too volatile, especially if they allocate a large portion of their portfolio to it. Investing solely in high-risk assets, like cryptocurrencies, could expose you to steep losses, while the same asset in moderation may add growth potential without significantly increasing overall risk.

Therefore, it is advised to hire a financial professional to clarify these nuances and build a portfolio that balances potential gains with risk. A financial advisor can help you make a personalized investment plan that aligns with your financial goals while keeping your risk appetite in mind. They can help you find the right mix of stocks, bonds, alternative investments, and strategies based on your risk tolerance.

To conclude

Balancing risk with return is essential to ensure that your investments do not overwhelm you and, at the same time, deliver returns that fit your needs and goals. While there are many ways to reduce risk, it is essential to remember that you can never entirely eliminate it. Risk is a natural part of investing. But with the right investment risk mitigation strategies, you can manage it to match your comfort level. Working with a financial advisor can be especially helpful, as these professionals can guide you in choosing the right investment assets and keeping risks in check.

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