Ways to Limit Risk for Ordinary People
- August 15, 2020
- by Michael
The words ‘risk’ and ‘reward’ come up often in investing. Simply put, risk is what you can lose. For example if you put $1,000 into a stock it can drop to zero for any number of reasons. In investing the reward, or the money you make, is generally expressed in as a percentage return. For example, the S&P 500 might have an average annual return of 8% for a given 10 year period. The general theory is, the bigger the risk the bigger the reward. Typically the bigger the risk, the higher the volatility as well, which means the price will take wild swings up or down.
Thankfully, investments come in a wide range of risk levels. Cash in an FDIC insured bank account is considered risk free, though the effect of inflation can erode its purchasing power. Bonds are slightly higher in risk vs cash but offer a slightly better rate of return to compensate for the extra risk. The riskiest investments are individual stocks, commodities, futures trading, currencies trading, options, etc.
The following concepts will help you look at investment risk as well as expected return.
Consider the Upside and Downside When Comparing Investments
If two investment options offer the same return, the next way to evaluate them would be to compare their risk level. If you can take less risk and get the same ROI (return on investment), that improves your overall portfolio.
For example, let’s say two rental properties are selling for the same price, rent for the same amount, are in the same shape in terms of repairs, and are in comparable neighborhoods. Given how similar they are, they would have the same expected return. However, if property A is situated in a flood zone, and property B is not in a flood zone, then property B would come with less risk than property A making it the better choice.
Diversify Your Investments
You can mitigate your risk exposure by diversifying your investments. This means selecting a variety of investments in different asset classes to help reduce your overall risk. A popular and easy way to diversify is investing through an index mutual fund or ETF that owns a slice of the entire market. Another common way to diversify is owning a large number stock and bonds. There have been many studies on the topic of how much diversification is enough, but the number seems to be about 20 - 40 stocks.
Diversification is important because it protects you from risk that comes from having all your eggs in one basket. As a hypothetical example, consider a non-diversified investor who loves Chipotle and puts 100% of their money into the stock. They are at risk both to what happens in the overall market (like a recession), but also if Chipotle has an accounting scandal, is responsible for an outbreak of e-coli, or there is a disruption in the supply of guacamole.
A diversified investor might hold stock in many restaurants, plus stocks in other totally unrelated industries. They would only suffer a relatively small loss if Chipotle ran into trouble. They might even come out ahead if when Chipotle dips, one of their competitors who they also own surges.
For people who work at companies that offer stock purchase options, lack of diversification can be a double whammy during a downturn. Not only does the value of their stock drop (which may be a big percentage of their retirement portfolio), they may also be out of a job.
They say diversification is the only “free lunch” on Wall Street, because it lowers risk more than it reduces upside. However, with diversification you will never hit a grand slam home run, such as putting all your money into Google or Netflix right after they went IPO. But who is crazy enough to do that anyway?
Review Your Asset Allocation
Like diversifying your investments, you should regularly evaluate how your assets are allocated. In other words, what percent of your portfolio is in stocks vs bonds vs real estate vs other kinds of “bets”.
Sadly, many investors do not track their asset allocation closely and don’t have a clue where their money is. It is important to note that watching your asset allocation does not eliminate risk, but it does help you gauge expected returns and expected risk.
At Wealth Meta we created a Portfolio Allocation calculator that looks at different stock vs bond mixes and does backtesting since 1928. This gives you an idea of what happened in the past only. The performance of any investment is not an indicator of how it will perform in the future.
There is no one-size-fits-all approach to investing, and your ideal asset allocation will change as your goals do. Some factors that affect your ideal asset allocation may include your age, how you expect to spend retirement, your risk tolerance, and more.
Many young investors prefer to take on a bit more risk. They have more time until retirement and do not typically have as much money in their investment portfolio as someone with more experience. Therefore, young investors might want to have more stocks in their portfolios as stocks are generally seen as higher-risk investments than bonds. As you get closer to retirement, your needs and risk tolerance may change.
Monitor and Rebalance Your Portfolio Regularly
Related to asset allocation is the need to rebalance your portfolio. Over time your allocation will naturally drift away from your desired set point. That is unless you are committed to being 100% in a single asset class your entire life.
Rebalancing is a technique for restoring your actual holdings from where they are currently, to where you’d like them to be. For example, let’s say an investor initially decided on an 80% stocks 20% bonds portfolio. If the stock market did really well recently they might end up at 82% stocks and 18% bonds. To rebalance they would sell 2% of their stocks and put that towards bonds to get back to 80/20.
Most experts recommend evaluating your portfolio at least annually. According to this analysis there may not be much benefit to doing it more regularly though, but probably not much harm either.
Avoid Impulsive Investment Decisions
When the market changes, it can be tempting to make an impulsive investment decision based on fear or greed.
If the stock market is declining you may feel compelled to protect yourself by selling before the market falls any further. This is actually one of the biggest risks investors face - pulling out of the market when they get scared. If they sell out and miss the rebound they just “bought high and sold low”.
On the other hand, if some hot stock keeps going higher and higher, you may feel compelled (by greed) to drop your “boring investments” and get in on the action.
Investing based on fear or greed usually amounts to placing a short term directional bet (eg, I think the market will keep dropping, or I think this hot stock will keep rising). Bets like that are generally very risky.
Experts recommend avoiding emotional investment decisions. This can mean holding on to your stock portfolio during a downturn in the market or resisting the urge to buy during a peak. They say “buy low” and “sell high”, but that is easier said than done because it goes opposite to the emotions of fear and greed which drive price movements in the markets.
This is why deciding on an asset allocation and sticking to it can be so powerful. If the market tanks and it is time to rebalance, it is just another opportunity to “sell high” of whatever is doing well in the portfolio and “buy low” of whatever is getting beat up at the moment.
Dollar Cost Average As You Go Along
You may want to consider a dollar-cost averaging investment strategy to help you avoid making impulsive investment decisions. Dollar-cost averaging is a strategy that investors use when automating contributions to their investment portfolios. A common example of dollar-cost averaging is contributing to your 401(k) plan each month, regardless of what the market is doing. The money goes in automatically. You don’t have to think about it. The bet you are making is that in 20-30 years (or whenever you retire) that the money will be there and it will have grown considerably.
The downside is, dollar cost averaging has been shown to lead to lower returns (since in general the market goes up in the long run). However, dollar cost averaging is what most people end up doing anyway as they save money over the course of their life.
Partner with a Financial Professional
As you evaluate your risk tolerance and other factors that will determine your asset allocation, it is wise to speak with a financial advisor. They can make recommendations on how to best structure your portfolio based on your situation. Ask what their fees are, if they get a commission on what they recommend, and what the associated investment costs are.
A financial professional will be able to help you navigate the market and give you personalized advice to help you reach your investment goals.
The Bottom Line
There is no such thing as a guaranteed investment. However, by doing some research and partnering with a financial professional, you can work to mitigate risk throughout the life of your investments.
For more information on how to organize your finances, consider using Wealth Meta’s financial tools. We have a net worth dashboard that helps you track your asset allocation, and a budget tracker to ensure you stay on course.