Risk management can help you create a successful investment portfolio by controlling the level of risk you take. It is possible to use different strategies to reduce or mitigate risk without necessarily impinging on your expected returns.
Risk management definition
The process of deducing the level of risk involved when making an investment decision. By understanding the expected return, the chances & scales for each potential outcome, and how an investment may work in combination with assets already held then a decision on whether or not to purchase the investment can be made confidently.
Ideally, we should aim for an investment strategy that gives us the highest return for the level of risk we are comfortable with. What follows are ways you can lower the risks of investing.
Risk mitigation strategies
This will allow you to benefit from pound cost averaging. Psychologically, this can be easier because market falls work to your advantage since you are purchasing assets at a cheaper valuation. This may therefore prevent you from selling in a panic in the event of large scale falls when it may not be in your interests. Also, it can prevent greed from taking over when markets rise. Both of which many ordinary investors can easily succumb to. To follow one of Warren Buffet’s rules;
“Be fearful when others are greedy and greedy when others are fearful”
As highlighted in our risk article investing this way gives a very high probability of decent market returns (71.33% chance of returns of 6%+ over 10 years increasing to 87.26% over 20 years).
Create investment objectives
Unless you have a goal it can be difficult to invest accordingly. Whether this is retirement, children’s education, to purchase a property or some other large financial commitment it is important to create a financial objective. Costing some of these may be difficult so you may wish to consult our cost of life infographic. With retirement costs now exceeding £1 million starting sooner helps.
Create an investment plan
Having a plan allows you to assess progress and modify your investments accordingly to give yourself the best opportunity possible to achieve your financial objectives. Planning comprises of 6 stages: objective, establishing a cost, assessing your savings requirement, modifying as required, investing accordingly, and monitoring progress.
Further information is available in our retirement planning article.
Concentrate on net returns
Establishing the true cost for certain investments can be difficult as highlighted by our shares vs property comparison. By concentrating on net returns you will be searching for the best performing assets for your risk. After all, if paying double resulted in returns twice as high, all else being equal, then it would usually be worthwhile.
Invest According to Timeframe
Adapting to the different time ranges reduces risk for a given return. Risk is comprised of volatility and time. To maintain a constant level of risk it is important to have higher levels of volatility in the earlier years and scaling this back as the investment objective draws nearer.
Know your objective
By knowing how much you wish to save then it is possible to time an exit strategy successfully. By monitoring your investments up to your goal then you can increase or decrease risk based on current market conditions. For example, if the stock market is riding high 5 years before your planned retirement date, resulting in you having a sufficient pension pot already, then it may be worthwhile moving into lower volatile assets. On the flip side, if you are invested in stocks and the markets are down then it may very well be worth holding on. Using the US S&P stock market there has been an 87.26% chance of receiving returns in excess of 6% p.a since 1900. However, the longest period returns were below this figure was 28 months between December 1940 & March 1943.
Investing in multiple different assets which have differing underlying investment characteristics depending on the economic climate. As no one knows what type of future will prevail having a diversified mix of assets should provide decent long term growth irrespective of what occurs.