Investing, by its very nature, carries with it different types of risk. Because of changes in interest rates, inflation rates, currency exchange rates, and managerial differences between companies, you will always face the risk that an investment will lose you money or that it will grow much more slowly than expected. To reduce financial risk to yourself, you must learn how to manage your investment portfolio well. There are several techniques involved in effective portfolio management.
1. Familiarize yourself with the different types of risk. Most financial risk can be categorized as either systematic or nonsystematic. Systematic risk affects an entire economy and all of the businesses within it; an example of systematic risk would be losses due to a recession. Nonsystematic risks are those that vary between companies or industries; these risks can be avoided completely through careful planning.
- There are several types of systematic risk. Interest risk is the risk that changing interest rates will make your current investment’s rate look unfavorable. Inflation risk is the risk that inflation will increase, making your current investment’s return smaller in relation. Liquidity risk is associated with “tying up” your money in long-term assets that cannot be sold easily.
- There are also different types of nonsystematic risk. Management risk is the risk that bad management decisions will hurt a company in which you’re invested. Credit risk is the risk that a debt instrument issuer (such as a bond issuer) will default on their repayments to you.
- Stocks are some of the riskiest investments, but can also provide the highest return. Stocks carry no guarantee of repayment, and changing investor confidence can create market volatility, driving stock values down.
- Bonds are less risky than stocks. Because they are debt instruments, repayment is guaranteed. The risk level of a bond is therefore dependent on the credit worthiness of the issuer; a company with shakier credit is more likely to default on a bond repayment.
- Cash-equivalent investments, such as money market accounts, savings accounts, or government bonds are the least risky. These investments are also highly liquid, but they provide low returns.
- If you are planning a big expenditure in the near future (such as a house or tuition), or you are retiring soon, you should aim for a relatively low-risk portfolio. This will help ensure that market volatility doesn’t cause your investments to lose a lot of value just before you need to draw money from them.
- If you are younger and investing for a long-term goal, more risk is appropriate. Long-term goals allow you to wait out stock price fluctuations and realize high returns over the long run.
- Allocating assets widely hedges against the risk that certain asset classes will perform well while others perform poorly. For example, if many investors begin buying corporate stocks, stock prices will rise; however, those investors may be selling bonds to fund their stock purchases, causing bond prices to fall. Spreading investments between stocks and bonds will protect against the risk of either category performing poorly.
- For example, if you buy stocks in 30 different companies, it is not likely that all 30 will perform poorly or go bankrupt at once, barring an economy-wide downturn. However, if you used the same amount of money to invest in only 1 company’s stock, the company may perform poorly and drag your entire stock portfolio down with it.
- You should constantly reevaluate your investment decisions based on your changing needs and the market’s changing shape. For example, as you get closer to retirement, consider putting a higher percentage of your money into low-risk investments.
- Markets do not generally reward risk that is unnecessary to shoulder. For example, investing in a company making poor managerial decisions could be avoided by analyzing those decision beforehand.