Ways to Lower Investment Risk

Risk is one of the largest determinants of the potential return on an investment. Finding that perfect balance between risk and return is a near impossible task, and often, investors find themselves with a portfolio offering a decent return but exposing their hard earned money to too much unnecessary risk. Fortunately, there are a number of ways to lower risk and lowering your risk does not have to mean lowering your expected return. In fact, there are some great options for creating a low risk or lower risk portfolio that still offer very good yields; I’ll cover these options in this article.

Diversification is Key

Diversification is absolutely one of the keys to creating a low risk portfolio. By diversifying, you are not putting all of your “eggs in one basket,” so to speak. Instead, you are spreading your capital across a number of different companies or investments. Investing everything you have into equities for instance can pose more risk than investing in a combination of stocks, bonds, real estate and other commodities.

Proper diversification of a stock portfolio would require a fairly large number of different stocks covering a wide variety of companies and a diverse array of industries. So for instance, owning 20 different technology stocks would be less diverse than owning one stock in each of the sectors of technology, healthcare, financials, industrials, utilities and consumer goods. In the first scenario, if something affected the technology sector or even one of the largest tech stocks, your entire portfolio could be adversely affected. On the other hand, by diversifying sectors as well as companies, a drop in one industry or corporation will not necessarily affect the others, thereby reducing your overall risk.

Consider Mutual Funds and EFTs

When first beginning to invest, some will argue that they do not have the capital available to diversify properly. They will buy one stock and pin their financial future on that one company. This is extremely dangerous and easily avoidable. There are two great options for those who either do not have the money to diversify properly or who really do not have the desire to research and follow so many different companies. Mutual funds and exchange traded funds or ETF’s are two great options for new investors and experienced investors alike. We will discuss mutual funds and ETF’s in depth in a later chapter so we will just touch on why they are great for diversification.

Both types of funds are basically a group or collection of stocks. Mutual funds are professionally managed, meaning that on a day to day basis, the mutual fund manager is actively trading the stocks in the fund. His role is to maximize the return of the fund while following the mutual fund’s investment objectives and goals outlined in its prospectus. Because there is a manager actively watching and trading all of the stocks in the fund, the cost for mutual funds can be relatively high. The tradeoff is of course that you have instant diversification and in theory, a professional manager seeking to maximize your return.

Mutual funds are sold with a number of options for paying the fees involved, which include sales fees and expenses. Some spread the sales fee out over the lifetime that you own the mutual fund while others charge an up-front fee, often called a load. All mutual funds have expense fees tied to them however, which pay for the funds operating expenses, which may include management fees and distribution or other sales fees. Fortunately, there are a number of mutual funds out there that have historically had high returns while charging no sales fee and fairly low expenses. These are the types of mutual funds you should seek, as expenses and fees can quickly eat away at your overall return on investment.

Exchange traded funds or ETF’s are similar in some regards but quite different in others. Like mutual funds, ETF’s are a grouping of investments, usually stocks. The biggest difference is that ETF’s are not actively managed. Instead, an ETF is put together and the stocks involved do not change. Because of this, the overall expenses are much lower, resulting in returns that often rival or exceed that of actively managed mutual funds.

Lowering Risk via Bonds

Bonds are a great way to diversify your overall investment portfolio. Bonds typically pay out a set amount of interest on a specified date. This cash can then be reinvested into something else or simply used as income, depending on your situation. Bonds have typically showed returns that are lower than equities, although in the recent economic downturn, bonds showed a nice return comparatively. Young investors may choose to only own equities, which is fine. However, as you get a little older, stable investments, such as bonds become more and more important. Bond buyers should diversify as well. It is important to purchase bonds from wide variety of issuers over a broad array of sectors. Another key to diversifying bonds is called laddering. This involves having bonds that come due over different periods of time. For instance, it would be wise to have bonds that come due in 10 years, 20 years and 30 years, rather than all being due in 30 years. We will discuss this more in the website chapter on Bonds as well.
Long Term Investments versus Short Term Investments

Speaking of time, this is another way to lower your risk. In reality, the risk taken with your money is generally the same on a day-to-day basis. However, when looking at a short-term versus a long-term investment timeline, the short-term is much more volatile and thus, risky. Over the long haul, most solid investments will overcome general market fluctuations and rise in value. However, over a short span, nearly every investment will fall in value at many different points in time. Counting on good results over a narrow range in time is very risky, since no one can predict what will make the markets move over the short term. The less time you have to save, the less risky your investment should be.

For example, let’s say you have two investors who wish to retire at age 65 with £1 million. Investor A is 30 years old and Investor B is 50 and both start with the same amount of money. Although the 50 year old has less time to accumulate his £1 million, he should be much more cautious and therefore willing to accept lower expected returns, even if it means he will not reach his goal. The reason is because of the risk of market adjustments and fluctuations. Imagine both place their money in the same investment and we fast forward 10 years. Both are nearing their goal of £1 million, with £800,000 each, now at age 40 and 60 respectively. Suddenly the market adjusts and both investors lose a quarter of their portfolio value, leaving them with £600,000. Investor A still has 25 years to make it up, while investor B only has 5. Had Investor B been more conservative, perhaps he would only have had £725,000 before the adjustment but since his portfolio was less risky, maybe he only loses 10% instead of 25%. He now has £652,500. Although he had accumulated less money, he now has more money than Investor A because he was smart enough to realize that he had to be conservative as a result of the shortened investment timeline.

Hedging Your Portfolio

One final way you can reduce your risk is to hedge your portfolio. Hedging is an investment practice that acts almost as insurance against a negative outcome. It does not prevent the negative outcome, does not completely counteract it and sometime does not even work at all. However, done correctly, a hedge will reduce your overall risk and can greatly aid in protecting your valued portfolio. We will discuss hedging in later chapters, but some of the possible hedge investments include commodities, gold, silver, forex and options trading.

All Investments Have Risk

There is no way to eliminate risk when investing; even investments that seem incredibly safe, and may very well be incredibly safe, have some form of risk involved. The key to smart investing is to minimize your risk whenever possible. The safest, most efficient and often most cost-effective way of achieving your goal of lowered risk is diversification. Diversify over a number of different companies in different market sectors and even over a wide range of investment types. In the long run, your bank account will be healthier and perhaps your heart too.