Managing Investment Risk
(4 of 5)
Managing Investment Risk
Risk is different from mere uncertainty. It is possible to analyze the risks inherent in an investment, and manage them in such a way as to increase your likelihood of returns and decrease your chance of losses. By strategically managing investment risk, you can take advantage of the higher return potential of higher risk investments.
Things To Know
- The most common risk management strategy is diversification.
- Asset allocation is an effective means of diversifying.
- Your time horizon can be key to managing your risk tolerance.
Diversification manages risk
The most common risk management strategy is diversification: combining investments in different kinds of assets into one portfolio, so that no one set of economic or market factors should not have too great an impact on the overall value of your investments. For example, if you invested all of your capital in petroleum stocks, a drop in gasoline prices could have a devastating effect on your portfolio. However, if you combined your petroleum stocks with investments in an industry that would benefit from a drop in gasoline prices—automobile manufacturing, for instance—the rise in one stock would potentially offset the drop in the other. Modern Portfolio Theory is built on the concept that risk is an inherent part of higher reward. The goal of Modern Portfolio Theory is to manage the risk-return relationship of a portfolio so that it gets the maximum return for the risk it accepts, and so that it accepts as little risk as possible to achieve a given return. All said, it should be remembered that diversification does not assure a profit or protect against loss.
One of the most broadly used diversification techniques is asset allocation: apportioning your investment capital among different asset classes (stocks, bonds, cash equivalents, etc). While asset allocation does not assure profit or protect against loss, research has shown that the way a portfolio is divided among asset classes is a better predictor of how well it will perform than which individual stocks or bonds are included. Using asset allocation, you place a portion of your capital in more aggressive investments, like stocks, and another portion in more conservative instruments like bonds.
Using your investment time horizon wisely
Finally, understanding your investment time horizon can help you increase your risk tolerance in the short term. Holding riskier investments for longer periods of time may help you overcome short-term drops in value. Stock investing is a good example: even despite market downturns, stockholders who keep their holdings long-term have seen greater opportunity for gains than those who relied on more conservative investments such as bonds. If your investment goals allow you to hold your investments for long periods, you can potentially benefit by pursuing a more aggressive investment strategy.