Do you worry about losing your money? If so, this isn’t necessarily all bad; worry can prompt you to make smart moves that lower investment risk when needed.
The following steps can all help reduce investment risk: increase the percentage of portfolio cash, diversify asset classes, buy undervalued assets, own noncorrelated investments, monitor bond risk, increase investment knowledge, estimate investment risk, increase risk awareness, use defensive assets and use historical data to evaluate investments.
In this post, I’ll delve into these 10 ways to reduce investment risk so you can sleep better at night while still journeying toward your financial goals. While I’m an AFC® (Accredited Financial Counselor), I learned these strategies from investing for 40 years.
While it may seem like you have to learn complex strategies to reduce investment risk, these practical ways to lower risk are simple to understand and use.
Increase the Percentage of Portfolio Cash
Increasing portfolio cash is probably the easiest way to reduce investment risk.
When you increase the amount of cash in your investment portfolio, you are eliminating the risk on the portion of your investment portfolio. Let me explain further.
Almost all traditional investment portfolios are divided between several types of investments, such as stocks, bonds, and short term debt, or cash. This is known as asset allocation in financial lingo.
More sophisticated asset allocation models include even more types of investments, such as international stocks, municipal bonds, commodity investments or defensive assets like TIPS.
Here is an example of a traditional asset allocation:
- Stocks – 50%
- Bonds – 35%
- Cash – 15%
All smart investors keep a portion of their net worth in cash. The amount of cash is generally based only on the age and risk tolerance of the investor but it is often around 10% to 20%.
There are other, more tactical factors that can be considered, though, besides age and risk by investors who want to lower risk from increasing portfolio cash.
One such risk factor is overvalued markets, for example. Overvalued markets are more expensive than normal.
When you pay for an asset over it’s average cost based on history, you’re increasing risk. The more expensive the asset class is, the more the risk increases.
For this reason, many risk-averse investors and proactive financial advisors raise the cash level of their clients to 30% or higher as markets become overvalued. Such a move accomplishes three outcomes:
- It allows investors to sell some assets (stocks or others) at overvalued levels
- It increases portfolio cash
- It provides cash so assets can be bought at lower prices
It’s impossible to know if the stock market will go up or down for sure at any given time, but investors can become more tactical by following the obvious clues. By selling assets as they become more expensive relative to historical valuations and increasing portfolio cash at the same time, investors create more opportunities to build wealth while also lowering risk.
Let’s look at this simple strategy more since it is the easiest way to lower investment risk.
Define Investment Cash First
To clarify, investment cash is not really cash. Investing or portfolio cash is invested into very short term types of debt. This debt is so short in time duration that it doesn’t move up and down in value.
These short term debt cash type of funds are commonly money market investments.
Since stocks and bonds move up and down in value, sometimes significantly, and money market funds don’t, simply increasing the percentage of portfolio cash is one of the best ways to lower investment risk.
The Dangers of Using Cash to Lower Risk
It’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 funds, however.
One danger with using too much cash to lower investment risk is inflation. Inflation depletes the 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 used to cost $250,000 in my distant memory. Now the same house is at least $500,000.
A great car that cost $20,000 a decade or two ago; a similar car now costs $ 50,000 brand new.
Inflation is a huge problem for investors who worry so much about investment risk that they keep high levels of portfolio cash. That cash is losing value every day.
Lowering investment risk with cash, then, does come at a price.
Cash Can Be A Little Too Comfortable
It feels safe to have extra portfolio cash. One problem with this financial comfort zone, however, is that it is easy to relax in cash through bull markets in stocks and other asset classes, all in the name of safety.
For investors who need to keep investment risk very low, higher levels of cash can make good sense, however. An example of this 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 will likely want to keep low levels of cash since risk management is a lower priority than it is for the eighty year old woman.
By clarifying investing goals and risk tolerance beforehand in a personal wealth plan, you can invest in assets with different risk levels in alignment with your own goals and acceptable risk.
My Ultimate Wealth Plan has the 12 kinds of investment risk and 49 ways to lower them. You can get it here now.
Diversifying Investments to Lower Investment Risk
This method to lower investment risk is also known as “not putting all your eggs in one basket”.
The more types of assets you own, the greater chance at least one asset will increase in price while the others go down. There are several layers of asset diversification.
First, investors can diversify among paper assets. This is the most common way to invest, by owning stocks, bonds, and money market funds.
Almost all investors do this. Unfortunately, most investors do only this.
A slightly more advanced investor may invest, however, in real estate through REITs, another paper asset. Investing in commodities by buying some ETF’s or mutual funds is another common “slightly” alternative investment that provides even more diversification.
Owning a portfolio of both offensive and defensive assets lowers investment risk. Stocks, bonds, money market, REITs, commodity ETFs, and mutual funds, however, are all still paper assets.
An investor may buy investments besides paper assets to take diversification a step further. For example, an investor may purchase real estate properties.
Then an investor may diversify even more among alternative investments. For example, the real estate investor may diversify into small business ownership by buying or starting an online business.
Such alternative investments are not as common since they are outside the realm of traditional investing models but they can be very effective ways to lower investment risk. They can also provide a way to lower another form of investment risk that accompanies bond investments; inflation risk.
Alternative investments in small business or real estate can also improve cash flow since they can lower tax expenses as well as increase income. This provides two more ways to lower financial risk, loss of positive cash flow and loss of income.
As you can see, diversification can be used in various ways and levels to reduce investment risk.
Undervalued Assets Lowers Investment Risk
Buying 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?
Investment risk is lower when the cost of the investment is lower, period.
Stocks can be bought at lower valuations for a multitude of reasons, including bear markets.
Real estate is another investment that goes on clearance about once a decade, on average.
In addition to reducing investment risk, the price you pay for an asset determines how much money you’ll make when you sell it. It’s easy to forget the simple fact that is it easier to build wealth when the purchase price is low.
Purchase Price – Sales Price = Wealth
There’s also the fact the cost is part of the investment income calculation. The lower the cost of an asset, the higher the yield.
Come to know and love simple tools to spot undervalued assets. Use more of your cash to buy undervalued assets when you find them.
By buying cheap, you’ll naturally capitalize on one of the best ways to reduce investment risk that has multiple benefits. Not only does buying bargains reduce risk, but it also enhances wealth building.
Own Investments That Move in Opposite Directions
An easy way for stock investors to reduce investment risk is to own what goes up when stocks go down in their portfolios. Assets that move in opposite directions are known as “non-correlated” assets in investing lingo.
This investment strategy can also be known as hedging. Hedging sounds sophisticated, 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 Treasury bonds to your investment portfolio along with stocks. Most traditional investors are already doing this. Investors flock to what’s considered safest during times of fear and uncertainty, financial crisis, or bear markets. US Treasury bonds are still considered one of the safest investments in the world.
It’s important to note that Treasury bonds don’t move perfectly opposite the US stock market. Stocks tend to go down more than bonds go up during bear markets. Nevertheless, most of the time, US stocks and US Treasuries are non-correlated, albeit imperfectly from a time and amount perspective.
Monitor Bond Risk
Many people don’t realize bonds have risks, too.
Like stocks, bonds also go up and down in price and value. Bonds have fewer long term moves up or down than stocks do since big interest rate cycles are very long.
There are many types of bonds, including U.S. Treasury bonds, corporate, and other entity bonds. When interest rates rise, however, almost all long term bonds decline in value.
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 investment income from interest and you could lose all your investment principle, as well.
You can lower risk by being aware that bonds have risk as well as stocks, and invest accordingly.
Even U.S. Treasury bonds have significant interest rate risk. 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 the Federal Reserve to make changes in interest rates to control the economy.
The good thing is that when bonds drop in value, you still get investment income from the bonds unless the issuing company or entity has financial trouble.
Knowledge Reduces Investment Risk
Getting smarter about the fundamentals of wealth building is 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 evaluate investments and find good opportunities. I often wonder why everyone isn’t as excited about investing.
When the financial jargon is thrown out, investing is 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 implement build wealth steps while lowering also risk.
In hindsight, most of my investment risk came from not knowing it existed. Learning about investing, then, and using that knowledge, can end most investment risk.
Control the Risk You Can
Even 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.
Factors that increase risk tolerance are:
- Higher levels of wealth
- Lower expenses
- Few dependents
- Several sources of income
- More time to accumulate wealth
- Investing knowledge
Some of these factors are under your control and others are not. Control the risk factors you can, and use your knowledge to manage the others.
|Way to Reduce Risk||Why It Works|
|Increase Portfolio Cash||Maintains Value and Provides Capital|
|Diversify Asset Classes||Lowers Risk from Any One Asset Class|
|Buy Undervalued Assets||Lowers Cost|
|Own Noncorrelated Investments||Some Assets Move In Opposite Directions|
|Monitor Bond Risk||Bond Risk Can Be Managed|
|Increase Investment Knowledge||Leads to Smarter Decisions|
|Estimate Investment Risk||Less Likely to Make Emotional Mistakes|
|Increase Risk Awareness||More Likely to Manage Risk|
|Use Defensive Assets||Various Assets Manage Various Risk Types|
|Use Facts, Math & Data to Evaluate Investments||More Informed Decisions|
Estimate Investment Risk
Clarify how much of a drop in the value of your investments you can tolerate without sacrificing your peace and happiness. Let’s see the formula for this next.
How to Estimate Stock Market Risk
If you have one million dollars in your retirement account, for example, see how much of a drop in net worth 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 out of your million dollar retirement portfolio.
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% for the S&P 500. (1). (The Nasdaq was much worse.)
Knowing this, grab your calculator.
What is $500,000 less 34%? Can you live with a decline of this amount in your stock portfolio? 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 you.
Sound scary? When we address our fears head on, they have less of a hold on us.
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. As a result, you’re less likely to act on investing emotions and more likely to make good decisions when stocks go down.
Defensive Assets to Lower Portfolio Risk
You can also consider your total investment portfolio in your estimated risk calculation.
Again, if you have U.S. Treasury bonds, there is a very high probability the bonds will go up when stocks go down thereby offsetting stock market risk. On the other hand, home values often decline during bear stock markets so this negative might offset any potential upside in increasing bond values from a net worth perspective.
If you have 25% of your investment portfolio in cash (safe money market accounts), for example, this asset 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 Risk
We all know investment risk is there yet it’s usually unaddressed. Investment risk is out of our awareness, but bringing risk into our awareness is one of the best ways to reduce investment risk.
Stocks tend to hold the most risk among traditional investments. Therefore it is prudent to bring awareness to the potential drop in your stock portfolio at any given time as addressed previously.
Once you have run the numbers and gotten your Stock Drop Factor, you’ll have a reasonable estimate of risk exposure. At that point, you can decide if you can live with the stock 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.
Making such choices will also help you remain calm during the next bear market.
How you invest and manage your money is based on choices. This awareness allows for more proactive and unemotional actions.
You’re more likely to build wealth from this place of knowledge and confidence than a place of avoidance and emotional investment decisions because you’re unprepared or indecisive.
You don’t feel like a victim to the economy or the financial markets when you are aware of your potential investment risk and have made choices from that place of awareness.
Use Reliable Facts, Math, and History to Lower Risk
This 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 the emotions of fear, greed, guilt, and shame instead of facts, math, and data. This reality has become so recognized even in 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 more intense 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 financial goals, you can shift from investing with emotions 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 Summary
Here you have 10 ways to lower investment risk while building wealth. Do some research and play with your own numbers to see if any of these risk lowering investment strategies make sense for you.
The best place to start is with my Ultimate Wealth Plan. You can get it here now.
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Source: 1. Moon Capital Management