3 STRATEGIES TO HELP REDUCE INVESTMENT RISK
3 STRATEGIES TO HELP REDUCE INVESTMENT RISK
History shows that when people invest and stay invested, they're more likely to earn positive returns in the long run.
When markets start to fluctuate, it may be tempting to make financial decisions in reaction to changes to your portfolio. But people who base their financial decisions on emotion often end up buying when the market is high and selling when prices are low. These investors ultimately have a harder time reaching their long-term financial goals.
How can you avoid making these common investing mistakes? Consider these strategies, which can help you reduce the risks associated with investing and potentially earn more consistent returns over time.
Strategy 1: Asset allocation
Appropriate asset allocation refers to the way you weight the investments in your portfolio to try to meet a specific objective — and it may be the single most important factor in the success of your portfolio.
For instance, if your goal is to pursue growth, and you're willing to take on market risk to reach that goal, you may decide to place as much as 80% of your assets in stocks and as little as 20% in bonds. Before you decide how you'll divide the asset classes in your portfolio, make sure you know your investment timeframe and the possible risks and rewards of each asset class.
Risks and rewards of major asset classes
- Can carry a high level of market risk over the short term due to fluctuating markets
- Historically earn higher long-term returns than other asset classes by a wide margin
- Generally outpace inflation better than most other investments over the long term
- Generally have less severe short-term price fluctuations than stocks and therefore offer lower market risk
- Relatively safe and tend to provide lower long-term returns and have higher inflation risks over time
- Bond prices are likely to fall when interest rates rise (if you sell a bond before it matures, you may get a higher or lower price than you paid, depending on the direction of interest rates)
Money market instruments
- Among the most stable of all asset classes in terms of returns, money market instruments carry very low market risk (managers of these securities try to keep the per-share price at $1 and distribute returns as dividends)
- Generally don't have the potential to outpace inflation by a large margin
- Not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency (there’s no guarantee that any fund will maintain a stable $1 share price)
- Different asset classes offer varying levels of potential return and market risk. For example, unlike stocks and corporate bonds, government T-bills offer guaranteed principal and interest — although money market funds that invest in them do not. As with any security, past performance doesn't necessarily indicate future results. And asset allocation does not guarantee a profit.
Strategy 2: Portfolio diversification Asset allocation and portfolio diversification go hand in hand.
Portfolio diversification is the process of selecting a variety of investments within each asset class to help reduce risk. Diversification across asset classes may also help lessen the impact of major market swings on your portfolio.
How portfolio diversification works
If you were to invest in the stock of just one company, you'd be taking on greater risk by relying solely on the performance of that company to grow your investment. This is known as "single-security risk" — the risk that your investment will fluctuate widely in value with the price of one holding.
But if you instead buy stocks in 15 or 20 companies in several different industries, you can reduce the potential for a substantial loss. If the return on one investment is falling, the return on another may be rising, which may help offset the poor performer.
Keep in mind, this doesn’t eliminate risk, and there is no guarantee against investment loss.
Strategy 3: Dollar-cost averaging
Dollar-cost averaging is a disciplined investment strategy that can help smooth out the effects of market fluctuations in your portfolio.
With this approach, you apply a specific dollar amount toward the purchase of stocks, bonds and/or mutual funds on a regular basis. As a result, you purchase more shares when prices are low and fewer shares when prices are high. Over time, the average cost of your shares will usually be lower than the average price of those shares. And because this strategy is systematic, it can help you avoid making emotional investment decisions.
How dollar-cost averaging might work in rising and declining markets
In the illustration below, the cost of the investment ranges between $10 and $25 from January through April. A fixed monthly investment of $100 buys as many as 10 shares when the price is lowest but only four shares when the price is highest. In this example, dollar-cost averaging results in a lower average share price during the period, while the market average price — for someone who bought an equal number of shares each month — is substantially higher.