Managing Risk
There’s no reason to beat around the bush about this:
Investing involves risk.
Given that fact, all investors should look for ways to minimize or manage investment risk. While you can’t eliminate it, you can take steps to keep it at acceptable levels.
Some examples of investment risk are:
- Market risk – Stock prices fluctuate for a variety of reasons.
- Interest rate risk – Rising interest rates cause fixed-income investments such as bonds to lose value and increase the cost of doing business for most companies.
- Inflation risk – Rising inflation can erode the value of income and/or assets.
- Credit or default risk – When a borrower can’t repay a loan, someone inevitably loses money.
- Currency or exchange risk – A rise in the value of the dollar buys more foreign goods, including shares. A falling dollar buys less.
- Timing risk – Whenever you make an investment, you’re betting that its value hasn’t already peaked and that better days lie ahead. But you may be wrong.
Strategies to Reduce Risk
Three strategies in particular can help you manage risk:
- Diversify
- Be patient
- Invest over time (dollar cost averaging)
Diversify
Financial advisors generally agree that most types of risk can be managed by diversifying – or “spreading the risk.” Dividing your investment dollars among different industries, countries and asset classes (stocks, bonds, real estate, etc.) helps cushion the impact that problems in one sector, industry or investment can have on a portfolio.
Mutual funds help spread the risk. For example, Pax World Balanced Fund generally invests at least 25% of its assets in fixed income securities to offset the higher risk of its equity holdings. And within its equity portfolio, the Fund diversifies among various industries and countries to spread the market risk further.
Be patient
Research reveals that time itself reduces risk in a very predictable way. Investment results can vary widely – from deep losses to huge gains – when looked at over the short term. But the longer the holding period, the lower the volatility and the greater the likelihood of positive returns.
In essence, time is on your side.
Invest over time (dollar cost averaging)
Lump-sum investing can produce spectacular returns – assuming your timing is right. But few professional investors consistently “time” the market correctly, and individual investors are notorious for timing it incorrectly, buying in droves at market tops and selling in droves at market bottoms.
For most investors, investing a fixed amount of money on, say, a monthly or quarterly basis provides a disciplined approach that can reduce investment risk and improve long-term returns. This systematic process is referred to as “dollar cost averaging.”
Dollar cost averaging does not assure a profit or protect you against a loss in a declining market. Because such plans involve making continuous investments regardless of fluctuating share prices, you should consider your financial ability to continue making purchases through periods of low prices.