Increase the Percentage of Portfolio CashIncreasing cash is one of the easiest ways to reduce investment risk. When you increase the amount of cash in your investment portfolio, you are eliminating the risk on that portion of your investment portfolio. Let me explain further. Almost all traditional investment portfolios are divided between a few several types of investments, such as stocks and bonds. This is known as asset allocation in financial lingo. More sophisticated asset allocation models include other types of investments such as international stocks or bonds, municipal bonds, or commodity investments. Here is an example of a traditional asset allocation:
- Stocks – 50%
- Bonds – 35%
- Cash – 15%
Define Investment Cash FirstTo clarify, investment cash is not really cash. Since investment cash is almost the same thing as the money in your wallet, let’s call it cash for simplicity, though. Investing “cash” is invested into very short term types of debt that don’t move up and down in value. These cash type funds are commonly money market investments. On the other hand, stocks move up and down in value as you already know. You have probably experienced a few big drops if you’ve invested in stocks for more than ten years. Drops of more than twenty percent are called bear markets. While smaller stock market corrections come along every year or two, bear markets are much less frequent but can ruin an otherwise solid retirement plan. Since stocks and bonds can move up and down in value, often significantly, and the amount in cash does not, simply having a higher percentage of a portfolio in cash is one of the best ways to lower investment risk. Click here to read my post What Percentage of Cash Should Be in My Portfolio with more on this.
The Dangers of Having a Lot of CashIt’s hard to imagine that having too much cash can be risky. There are a few problems that come with too much portfolio cash, or money market accounts, however.
Inflation RiskThe most common danger is inflation. Inflation depletes that value of your money by about 3% a year on average. While sometimes there are different “ation” scenarios, such as deflation and stagnation, inflation is the one that most commonly robs retirees of their desired lifestyle. You’ve seen inflation firsthand every time you shop with the disturbing memory of lower prices. Nice urban houses cost $250,000 in my distant memory. Now the same house is at least $500,000. A great car cost $20,000 a decade or two ago. A similar car now costs $ 50,000 brand new. (This is another reason why I buy used cars, but that’s another post.) This is the big problem for people planning to live off their investments: The money sitting in cash type of investments (called “cash equivalents” in financial lingo) looses it’s purchasing value by about 3% a year on average. Lately, inflation has been closer to 2%. Think how much this depletes the value of your money over ten years! Inflation is a real risk with cash (and bonds).
Financial Companies DefaultThis is so rare that I hesitate to mention it. Nevertheless, when I invest in a money market fund, I check first to see how much it’s insured for and by whom. This almost eliminates default risk if the fund is covered adequately. This is particularly important for high net worth investors who have a lot of portfolio cash.
Cash Can Be A Little Too ComfortableCash is comfy. It feels great to have cash. One problem with this financial comfort zone is that it is easy to relax in cash through bull markets in stocks, bonds and real estate, all in the name of safety. At times, however, low risk can be the most essential element of investing. An example would be an eighty year old woman who has just enough money for the rest of her life. A single thirty something with a high paying job and no dependents can have safe investing as a much lower priority. By clarifying investing goals and risk tolerance in a personal wealth plan beforehand, you can invest in alignment with those guidelines.
Fear of Missing OutNote that the comfort of investing in cash, on the other hand, can sometimes have a certain level of guilt. There is a constant fear of missing out or feeling like you “should” be invested in stocks. Fear of missing out has become such a real phenomenon that it is now well known as FOMA. While very long term investing in stocks can build wealth passively over time, not everyone has decades to invest before retiring. This FOMA often leads investors with urgent goals but little time to jump into overvalued markets.
Cash Is an Asset ClassLest we not forget: Cash is an asset class. The rare reality is that sometimes cash can make the most sense for a substantial portion of your investment portfolio. This can happen when all types of investments are near market high, or you need zero risk based on your age or other factors. Sometimes the more obvious investments in stocks, bonds and real estate are all overvalued. There are almost always diamonds in the rough, however. It just takes a little more knowledge and effort to find them, but it is rather fun when you do.
Diversifying Investments to Lower Investment RiskThe remaining ways to lower investment risk will stem from the points made above about asset allocation and valuations. This risk lowering investment strategy is also known as “don’t put all your eggs in one basket”. The most common way to diversify is by investing in stocks, bonds and money markets. A slightly more strategic investor may invest in real estate through REITs. Investing in commodities by buying some ETF’s or mutual funds is another common alternative investment. A step further could lead an investor to owning real estate properties or oil and gas partnerships. Click here to read my related post Income Producing Assets That Shine. Or another step for an investor with lower net worth may be investing in your own skills, business, or someone else’s small business with sweat equity. Click here to read my related post with 115 Cool Businesses to Start Later in Life. These alternative investments are not as common since they are outside the realm of traditional wealth management but can be very effective ways to lower investment risk. And they can provide a way to lower inflation risk, too. Alternative investments in real estate and small business can also improve cash flow since they can lower tax expenses as well as increase income.
Buy Undervalued AssetsBuying undervalued assets is one of my favorite ways to lower investment risk. We naturally seek the best airfare, car deals, and appliances. Why in the world wouldn’t we also seek undervalued investments? Stocks and real estate go on clearance one to three times every decade, on average. And the price you pay for an asset determines how much money you’ll make when you sell it. It’s easy forget the simple fact that is it easier to build wealth when the purchase price is low. Purchase Price – Sales Price = Wealth Come to know and love simple tools to spot undervalued assets. Use more of your cash to buy assets when you find them. By buying cheap, you’ll naturally capitalize on one of the best ways to reduce investment risk. Not only does buying bargains reduce risk, it enhances wealth building. A great way to find undervalued investments is by simply looking at what everyone hates. This comes with the territory. Click here to read my post related How to Build Wealth with more on wealth building with undervalued assets.
Own Investments That Move in Opposite DirectionsThis investment strategy is also one of the easiest ways to reduce investment risk. Assets that move in opposite directions are known as “non-correlated” assets in investing lingo. This strategy can also be known as hedging. Hedging sounds sophisticated. It sounds like something only financial professionals can do. The truth is that you can hedge, too, when you buy an investment that typically goes up and when another investment goes down. The most common and uncomplicated way to hedge is to add US Treasuries to your stock portfolio. Investors tend to flock to what’s considered safest during times of fear and uncertainty. US Treasuries are still considered one of the safest investments in the world. (Remember, though, that long term bonds go down when interest rates go up.) It’s important to note that Treasuries don’t move perfectly opposite the US stock market. Nevertheless, most of the time, US stocks and US Treasuries are non-correlated.
Monitor Bond RiskMany people don’t realize bonds have risk, too. Bonds also go up and down in value, but bonds have fewer big, long term moves up or down, known as cycles. This is because big interest rate cycles are very long. There are U.S. Treasury bonds and there are corporate and other entity bonds. When interest rates rise, almost all long term bonds decline in value. The good thing is that when bonds drop in value, you still get interest income from the bonds unless the issuing company or entity has financial trouble. Bonds drop for other reasons, too, especially bonds other than U.S. Treasury bonds. One risk with bonds is that the company or entity that issued the bonds can go broke. In this case, unfortunately, you probably won’t continue to get your interest income and you may. You can lower risk by being aware that bonds have risk as well as stocks, and acting accordingly. And even U.S. Treasury bonds have interest rate risks. If you own notes or bonds in your portfolio, check the duration to get a better idea of the risk potential. Duration is simply the number of years until the bonds mature. Remember, longer terms bonds decline more when interest rates rise. Without making it too complicated, note that the growth or slow down in the economy usually drives bull and bear stock markets. This makes sense. And the Federal Reserve changes interest rates to control the economy. This makes sense, too.
Learn About InvestingGetting smarter about investing is one of the best ways to reduce investment risk. It’s also one of the simplest and cheapest ways to reduce investment risk. And learning about investing is definitely one of the most fulfilling ways to reduce investment risk. It just feels good to understand something as important as your investments. Call me a nerd but I find it very rewarding to find good investments. I often wonder why everyone isn’t as excited to increase their investing skills. When the financial jargon is thrown out, it’s not rocket science. It’s logical. The truth is that knowledge is power. It just stands to reason the more you know about investing the easier it will be to build wealth while lowering risk. My experience has been that most investment risk came from not knowing it existed. Learning about investing, then, and using that knowledge, ends most investing risk.
Investment Risk Vs RewardEven with all these ways to reduce investment risk, there is a trade off between risk and reward. As written earlier, smart investing begins with getting super clear about your goals, and clearly defining how much risk you want in your portfolio before ever investing. Factor’s that increase risk tolerance are:
- Higher levels of wealth
- Lower expenses
- Few dependents
- Several sources of income
- More time to accumulate wealth
- Investing knowledge
Estimate Investment RiskClarify how much of a drop in the value of your investments you can tolerate without sacrificing your peace and happiness.
How to Estimate Stock Market RiskIf you have $1,000,000 in your investment accounts, for example, see how much of a drop in net worth (of a few years) you can handle? You can do the math with my Stock Drop Factor process. For example, let’s assume you have $500,000 in stocks. Bear markets have historically occurred about every three and a half years and drop around 34%, on average. Between 1946 and 2009, the bear market drop range was between -22% and -57%. (1). Knowing this, grab your calculator. What is $500,000 less 34%? Can you live with that number? I call this your Stock Drop Factor. Keep in mind that this decline of 34% is only an average decline based on past bear stock markets. I like to think the magnitude of the 2008 bear market won’t occur again in my lifetime, but it could. For a more modern version, you may want to use the 57% drop from the 2007-2009 bear market to know how a bear market will affect your stock portfolio. Click here to read my related post How Will a Stock market Crash Affect You?
Using U.S.Treasury Bonds to Lower RiskAgain, if you have U.S. Treasury, some of this risk will likely be offset by a rise in these bonds. On the other hand, home values usually decline in bear stock markets so this negative can offset any potential upside in increasing bond values from a net worth perspective. Sound scary? When we address our fears head on, they have less of a hold on us.
Cash to Lower Portfolio RiskYou can also consider your total investment portfolio in your calculation. If you have 25% of your investment portfolio in cash (safe money market accounts), this money should not decline at all. And the portfolio cash can be used to buy undervalued assets, likely reducing risk more, as covered earlier.
Awareness to Lower Investment RiskThere is a certain peace in looking at the likely potential drop in your stock portfolio at any given time. Once you have run the numbers, you can decide if you can live with the risk you are choosing to take in your portfolio. If you can’t live with the risk in your portfolio, you can choose to make changes. On the other hand, you can choose to be calm in the reality of the next bear market. How you invest and manage your money is based on choices. This approach removes feeling like you’re a victim of the stock market or the economy. It allows for proactive and unemotional actions. And this is more likely to build wealth than avoidance and emotional decisions about your investments because you don’t understand your investments or you’re afraid. You don’t feel like a victim to the economy, your boss or the financial markets when you are aware. When you have taken just a few minutes to estimate the potential risk in your stock account based on historical facts, you are more empowered than you were 5 minutes prior. If investors had done this simple process in 2001 and 2007 they would have been much better prepared to manage the net worth declines that almost certainly occurred in 2002 and 2008. And they may have also had extra portfolio cash to take advantage of undervalued assets to build wealth while lowering risk.
Use Reliable Facts, Math and History to Lower RiskThis sounds so simple but it can make such a difference in both your wealth building and your happiness. Almost everyone makes investment decisions influenced by fear, greed, guilt and shame. This reality is so accepted among mainstream investing now that it has been given a name: behavioral finance. In essence, behavioral finance says that we all have biases based on our past experiences with money and investing. Not only this, but the pain of investing mistakes is much greater than the joy of investing success. This sounds crazy but as humans we are wired to survive, and feeling pain more than joy helped us to survive back in the cave dwelling down. Now we can let go of the pain of investing mistakes and the accompanying fear it triggers. By focusing on what you have accomplished from your investing, and the joy you will have as you accomplish your goals, you can shift from investing with fear to investing with logic. All the ways to lower investment risk in this post are based on logic, math and historical facts. Deep rooted fear of running out of money, which taps into our survival instincts, can sabotage logical investing strategies. Choose to allow facts and historical data to override emotions or risk avoidance.
Ways to Lower Investment Risk SummaryHere you have 10 ways to lower investment risk while building wealth that are based on math, logic and history. Play with your numbers and do some research to see if any of these risk lowering investment strategies make sense for you. Then make it happen.
The information on this website is for education only and is not to be construed as personal financial advice.