Risk management is about preparing your investments from the get-go so that you can successfully achieve your financial goals. Investing entails risk. When you invest, you risk losing money when the markets go down. If you take on too much risk, you could be more susceptible to making harmful investment decisions that could compromise your long-term financial goals.
But the solution isn’t to avoid investing altogether. If you do not invest, you may not be able to achieve your financial goals either. Instead, the key is to manage your investment risk, so that you don’t take on more than you’re comfortable with. Here are a few ways you can manage your investment risk.
1. Diversify your investments
Let’s say you’ve invested most of your savings in the stock market. If it crashes, you could lose a significant portion of your net worth and jeopardise your financial well-being. Putting most of your wealth in one asset is called concentration risk, which means that you risk losing money due to a single event.
You can reduce concentration risk by diversifying your investments. Diversification lets you earn a return from holding riskier assets while minimising the negative impact a single asset or asset class can have on your wealth. For example, a portfolio with equities, bonds and commodities earns a return from the risky part of the portfolio (equities) while the protective assets (bonds, and gold) limits your downside if the markets go down. In addition, a portfolio that’s also diversified across different countries lets you earn from high-growth economies while reducing the impact of event risks, such as political turmoil and natural disasters, on your overall portfolio.
And rather than concentrating all of your savings in a single portfolio, you can have multiple portfolios with different asset allocations depending on the time frame of your goals. For instance, you can have a portfolio with a greater allocation to riskier assets if your goals have a longer time horizon. Higher-risk portfolios may be more volatile in the short term, but can potentially generate greater returns in the long run.
2. Practise dollar-cost averaging
Often, market timers make investment decisions based on emotions, not sound investing principles and proper risk management. For instance, investors driven by the fear of missing out will buy too much when markets go up, taking on more risk than they can handle. But when markets inevitably go down, they can’t stomach the risk so they start offloading their holdings at a loss. Even if you’re level-headed and rational, it’s almost impossible to outperform the market by timing it.
Instead, you should invest systematically through dollar-cost averaging (DCA). By committing to invest in the market on a regular basis regardless of whether the markets go up or down, DCA spreads your risk exposure across multiple price points over time. Contrary to what market timers believe, there isn’t a wrong time to invest, as long as you don’t only invest once. With DCA, you buy more units when prices are lower and average out your purchases when the markets are going up, which minimises your investment risk overall.
3. Stay invested to avoid opportunity loss
In the long term, markets have historically gone up. So, the most beneficial thing you can do for your investments is to stick to your long-term financial plan and stay invested. By staying invested, you give your investments the opportunity to compound effectively and earn greater returns in the long run.
You might be tempted to cash out when markets are declining, hoping to buy back in at the bottom. But no one knows where the bottom is. You risk missing out on potential gains when the markets go up if you cash out early.
During the 2008 financial crisis, the S&P 500 bottomed on March 9, 2009 and went on to gain almost 65% by 31 December 2009. At the time, investors didn’t know that the recovery had started. Even a year later, many still argued that it wasn’t the right time to enter the market. Had you not been invested during that period, chances are you would have missed the opportunity to ride the market’s upward momentum.
Managing risk is key to reaching your investment goals
All investing entails risk. The trick is to align the level of risk with your needs and goals. Understanding and managing your risk through diversification, dollar-cost averaging and staying invested can help you reach your investment goals.
