Ways to Reduce Risks in Investments
“Successful Investing is managing risk, not avoiding it.”
Benjamin Graham, the father of value investing might have said this decades ago, but it still holds true. Any investment entails some element of risk. Depending on the asset class and the underlying investment attributes, the risks would differ. If you are investing without understanding and managing risk, you are playing a dangerous game. We cannot completely eliminate investment risk, but we can definitely reduce it by managing it effectively. Now, you must be wondering how we should manage the risk? In this article, we will explore some smart ways to reduce such investment risk.
Every asset class and the related investment is vulnerable to certain risk factors, and the most common mistake investors make is not understanding and/or ignoring such risks. When we are investing, we need to adopt investment risk management strategies for reducing losses and investment risk. Optimum risk management can help you grow your wealth and achieve financial goals with ease. So, let us discuss 7 smart ways to reduce investment risks.
(a) Know your Risk Tolerance Capacity:- Risk tolerance refers to the ability of an investor to pursue the risk of losing the capital. Risk tolerance mainly depends on your financial obligations and age. As a general rule, younger investors tend to be more risk-tolerant than older investors. Knowing your risk tolerance will allow you to focus on instruments that match your risk appetite. It is critical to understand how much risk you can take and invest accordingly.
(b) Maintain Adequate Liquidity in Your Portfolio:- One thing that COVID has taught us is that a financial emergency can strike at any time! So, in the event of an emergency, we may need to redeem our investments anytime, even when the markets are down. This risk can be mitigated by maintaining adequate liquidity. Having liquid assets in your portfolio can help you in uncertain times and act as your financial guard. One of the ways of maintaining sufficient liquidity in your portfolio is by setting aside an Emergency Fund that should be equal to 6 to 8 months of expenses.
(c) Implement an Asset Allocation Strategy:- Asset allocation can be a crucial point to your overall investing pattern and one should have own asset allocation strategy rather than mimicking others. There are asset classes available to invest like Equity, Debt, Real-Estate, Gold, Commodities, Alternative Investments, etc. To help ensure the success of your portfolio, you may consider employing an asset allocation strategy that involves a mix of assets that are negatively correlated; for instance, when one asset class is not performing well, the other asset classes should perform well, reducing the overall risk of the portfolio. Here in India, retail investors primarily invest in Equity, Debt with some exposure to Gold.
(d) Diversification:- By diversifying your portfolio across different asset classes, products, sectors, industries, etc., depending on the underlying product, you can reduce the overall investment risk, specifically the unsystematic risk which is limited in nature and not affecting the entire market uniformly. If you are investing in Equity Mutual funds, then you can diversify by investing in large, middle or small-cap equity mutual funds, style of investing and also at the AMC level. Diversification gives the portfolio some cushion for specific risks arising in select investments. However, diversification only to a point is logical and over-diversification is not recommended. The reason is, you may not get any additional benefit for diversification, the question of manageability and lastly, you may find non-performing investments creep into your portfolio. Warren Buffet once said, "wide diversification is only required when investors do not understand what they’re doing".
(e) Focus on Time in The Market:- In the formula of compounding, the variable of ‘n’ - period makes the real difference. Here, people often focus on ‘r’, i.e. how much return will it give, but ignore the ‘n’ factor. The holding /investment period also matters a lot in managing risk, especially when it comes to equities. We all know, equities are far too risky in the short term as it gets impacted by news, events and so on. But in the long term, the price growth would mimic the profit or revenue growth of the company. Risk management can be also done when you match the ideal investment horizon with the asset class. In equities, your focus should be to spend as much time in the market and forget about timing the market, which no one can predict.
(f) Due Diligence:- It is always important to conduct due diligence before investing. If you are buying a stock for long-term investment purposes then you should consider the quality of management, the fundamentals and also the technicals while making buy/sell decisions. That’s a lot for a normal investor. Investing through mutual funds eliminates this to a large extent but still requires some due diligence and this is where a mutual fund distributor helps a lot. If you blindly follow the tips of others and from what you hear and read in popular media, without your own research, it will lead to losses.
(g) Monitor Regularly:- Having created a portfolio, one also needs to monitor their portfolio regularly. If you’re a long-term investor, that doesn’t mean that you invest and forget about your portfolio in this fast-paced world. Periodic reviews aid in identifying and closing the gaps. With time, your portfolio asset allocation changes, the economic fundamentals change, the personal risk profile and investment objectives change, the attributes and performance of underlying investment avenues also change, and so on. If you do not monitor your investments on a regular basis, the risks in your portfolio also increase. As a result, keeping track of your portfolio becomes critical and it is recommended that you revisit and review your portfolio at least once a year.
Summing Up
As every investment involves some risk, it is impossible to construct an investment portfolio that guarantees zero risk. However, by implementing the strategies discussed above, we can ensure that you will be able to find the appropriate balance between risk and return. Optimum risk management allows your investments to grow and help you to achieve your financial goals with ease.