Updated Sept. 6, 2021, 2:35 p.m.
As a smart investor you must understand how to keep your investments safe in order to protect your fortune against the worst case scenarios.
Risk management is critical for reducing uncertainty in investing. One goal here is to make it apparent that the overall direction of your investments gives positive returns by lowering volatility in your portfolio. Though your personal strategy may be different based on your risk tolerance, here are some guidelines to follow which prioritize lowering risk over potentially boosting reward.
The more you learn, the more you earn. Research into high value stocks with the intent of investing in the long term. This requires choosing companies you believe are underpriced but have the ability to grow in the future. Stick with them for years to come so your wealth grows alongside them. By doing research and becoming familiar with their business, you will gain the confidence to stand by each investment despite potentially daunting price fluctuations.
The companies that tend to have more stable growth are long established and have large market capitalization. There are a number of metrics you can use to help determine the value of a company, like the stock’s price to company earnings ratio (P/E), but keep in mind that no single one provides valuation with certainty. A business with a higher P/E ratio than a similar company may indicate greater risk because investors expect more future growth than current earnings.
Give yourself the chance to think about the quality of your investment. What you don’t want to do is pour your money into a stock immediately after getting a tip that it will boom. It’s a dangerous situation to feel stressed on time to purchase a stock out of worries that you’ll miss out on the hype. Remember that value investments shouldn’t double in price within a short timespan. Rather, they should provide steady returns over decades.
Imagine having a large sum of money ready to be invested into a first-rate stock that you personally selected. Do you invest all of your money immediately? What if it suddenly drops after your purchase? If you wait too long because of these concerns and the price instead rises, then you might regret not buying it sooner.
The solution is a compromise of purchasing a small stake at a time and to not worry about exactly when to buy. Through dollar cost averaging you invest incrementally at regular intervals instead of investing a lump sum all at once. For most people, it may be more comforting to contribute $1000 at the beginning of each month for a year rather than putting in $12000 right away. The main benefit of this tool is that it eliminates a psychological barrier which delays or even prevents investing.
This takes trying to time the market out of the equation and should be automated, regardless of the price being at a high or low. No investor can reliably predict whether the stock price is at a low or peak, anyways.
Cost averaging constrains the price movement of a stock to go with the long term trend and it minimizes your risk of significant loss during a market sell off. Though this is considered more safe, the downside is that your returns become less likely to beat the market, as with most risk management tools.
Historically, it has been found that lump sum investing often outperforms cost averaging. This makes sense because a smaller portion of your assets in the market limits your growth in a rising economy, and you might miss out on days with positive company reports. However, the idea is not to maximize your potential growth, but to invest consistently and reduce volatility.
Some companies distribute a portion of their profits to shareholders in the form of cash dividends as a reward for their loyalty. Stocks which pay dividends are an excellent lower risk option to add to your portfolio. Because they have free cash to pay out, dividend yielding companies are seen as financially responsible and have earned the confidence of their investors.
Dividends are a fixed source of income that remain stable even as the market falls, and these earnings also have lower taxes at a long term investment rate. Since this money comes from company profits, their growth may be limited but are also more steady. Investors often reinvest their dividends back into the company to accelerate returns; accordingly, dividends account for most of the historical returns in the S&P 500.
You wouldn’t want to put all of your money into a single company. That’s basically carrying all of your expensive eggs in one basket.
Proper diversification involves evenly spreading your investments across a large number of companies and a variety of economic sectors to balance out your portfolio’s risk. In the event of a particular stocks’ or sectors' poor performance, the majority of a diversified portfolio would protect your overall investments. A good number to gain most of the benefit of diversification is to equally spread capital across at least 20 companies, so that not one stock represents more than 5% of your portfolio.
The 11 different market sectors, in order of greatest representation of the S&P 500 to the least, are:
| Information Technology (Tech) |
| Health Care |
| Consumer Discretionary (Cyclical) |
| Communication Services (Telecom) |
| Financials |
| Industrials |
| Consumer Staples |
| Utilities |
| Materials |
| Real Estate |
| Energy |
It is advised to have exposure in each of these industries because many of them grow independently from one another. Some sectors are defensive and more stable during periods of volatility because, for example, everyone still needs basic utilities in hard times.
Also important to note is cryptocurrency as it is an emerging market where you can capture great profits. Be aware that crypto is highly volatile at this stage so despite the temptation, exposure should be limited to perhaps 5% of your total investment portfolio.
Other considerations for diversification of stocks are the size of the company (market cap) and the geographical region. Though there is more associated risk, emerging market economies in different regions as well as smaller cap stocks both have greater potential for growth.
It may seem impossible when starting out with limited capital to achieve an appropriate amount of diversification, but thankfully there is an easy solution. Having a diversified portfolio can also be made simple through purchasing mutual funds, index funds, and exchange traded funds (ETFs), which represent the broader market in one package.
There are all kinds of funds to choose from: some that represent individual sectors like tech, dividend focused ETFs, small cap stocks, and even the S&P 500. With these you invest in a large number of companies and a variety of industries to reduce risk, which would otherwise be a challenge for smaller accounts.
Keep in mind that some of these packages may charge higher fees than others and their availability might depend on the type of investment account. Actively managed funds like mutual funds try to beat the market and charge higher fees for this, but they often underperform compared to the overall market. Passively managed funds like ETFs have lower expense ratios and have a better chance of capturing the market’s returns.
You can also diversify with different types of investing than stocks. Especially as you age, your funds should be reallocated towards lower risk assets and away from stocks. This matters during retirement age because stocks pose a greater risk in the short term and losses might not have the time to recover. Among your options for lower risk investments are certificates of deposit, municipal bonds, real estate, and commodities.
Certificates of deposit (CDs) are among the safest methods to preserve wealth, earning only a small amount of interest. A CD is an agreement between you and a financial institution where you leave with them funds for an established term and earn interest until it matures.
Alternatively, you can purchase commodities like gold, base metals, and crude oil to preserve wealth. This traditional type of investing protects against inflation during times when certain goods increase in demand.
Real estate is the most popular investment that most people are involved in as they raise equity into their home, and this market grows more independently from the stock market. Real estate investment trusts (REITs) are traded on stock exchanges and are a good option for diversifying, without having to delve too far into the world of real estate.
Another option is to purchase bonds, which pay a fixed income of more modest returns. Bonds are favored as a reliable source of income due to low volatility, but they still carry risk because they depend on interest rates. Consider a mix of government and corporate bonds with varying levels of maturity, credit quality, and geography to further reduce risk within this category.
It is often recommended to invest a larger portion of your assets into bonds or other low risk options as you approach retirement to lower your risk and preserve your wealth. One rule of thumb is to subtract your age from 110 to figure what percent of your portfolio should be in stocks. For example a 30 year old would allocate 80% of their funds into the stock market, and the remaining 20% could be bonds.
In summary, when you reduce risk you may narrow your potential profits, but it’s important for stable growth of your wealth. You can reduce risk with research into value stocks, investing into dividend stocks, through dollar cost averaging, and by diversification. Diversify through different types of investments, and by investing a large number of stocks across different industries, company sizes, and geographical regions.
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