Every investment carries inherent risk. Even holding cash exposes you to inflation. There’s no secret formula that will erase all risk, but you can certainly lower your exposure. There are strategies and tools you can use to help mitigate a lot of the upfront risk. Here are 7 ways to reduce investment risk:
1. Diversification
Keeping all your eggs in one basket is a risky bet. In market downturns, well-diversified portfolios tend to outperform concentrated ones.
The deeper and more broadly diversified your portfolio, the better your chances of mitigating the risk.
2. Non-correlating assets
There is a systematic risk. Reduce this systematic risk by adding non-correlating asset classes like bonds, currencies, commodities, and real estate to your portfolio. Negative correlating assets typically move in inverse ways compared to stocks in the market. The advantage here is when one asset class is down, another is usually up. This helps smooth out the volatility of your total portfolio.
3. Put options
You can reduce your risk by buying put options to insure your portfolio against falling prices. A very effective way of limiting your risk. But partial or full insurance cost you a premium that has to be paid for the put option.
4. Stop losses
Simply place a stop loss. Hard stops trigger the sale of a stock at a fixed price that doesn’t change. Trailing stops move with the stock price.
5. Dividends
You can reduce risk in several ways. Studies show companies who pay high dividends tend to grow earnings faster than those that do not. Faster growth usually leads to higher share prices which generate higher capital gains. So, you reduce risk by increasing your overall return.
If stock prices fall, you have the cushion of dividends paid to you. Dividends also are a good hedge against inflation.
6. Cost Averaging
Cost averaging means, you apply a specific amount of your money toward the purchase of stocks, bonds, or mutual funds on a regular basis. You end up buying more shares when prices are down and fewer shares when prices are up. The average cost of your shares usually is lower than the average price of those shares. The advantage here, the regular purchase can be automated, removing any emotional decision making.
7. Due Diligence
Do your research before you invest. Look at the investment’s history and fundamentals like earnings growth, debt, etc. You should compare similar investments as well as other assets in your portfolio.
Sven Franssen