Average investors are not so great at managing investment risk. They seem to sell when they should buy, and buy when they should sell. You can see how that behavior works out in Why Average Investors Earn Below Average Returns.
To get better results, you need to learn how to manage investment risk successfully. Below I’ve outlined four ways to manage investment risk. You may wish to use all of them, or you may choose to employ only one or two.
1. Avoid Investment Risk
You always have the option to avoid investment risk by choosing only safe, guaranteed investments. Choosing to avoid investment risk is one of the smartest decisions you can make until you have learned the skills you will need to manage risk appropriately.
Start your search for safe, low risk investments here:
2. Diversify Your Investment Risk
Managing investment risk through diversification, simply said, is “don’t put all your eggs in one basket.” This is the traditional approach to investing that you’ll see promoted by many financial advisors and popular personal finance magazines and books. Investment diversification is important. I advise you do it. I also advise you understand its limitations.
Diversification does help reduce investment risk, but you must remember that the long term results of a diversified set of investments are far from certain.
Learn more about how to manage investment risk through diversification and asset allocation here:
3. Only Take Calculated Investment Risks
Warren Buffett is considered one of the greatest investors of our times. He has said, “You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.” This is the concept behind taking calculated risks.
Employing a calculated risk taking strategy takes knowledge, research and common sense. It is not an autopilot approach. To learn how to take calculated risks you have to understand how to view markets from a logical and rational approach – not an emotional one. You also need to understand certain ratios and indicators you can use to help you assess the market.
One ratio some financial professionals use in an attempt to determine if the stock market is overvalued or undervalued is the price to earnings ratio, or P/E ratio. Another indicator of recessions is the yield curve. The process of making investment decisions based on a calculated form of risk taking is often referred to as tactical asset allocation.
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4. Insure Against Investment Risk
The last strategy you can employ to manage investment risk is to insure against it. If you have car insurance, homeowner’s insurance, health insurance, or any other type of insurance, you are already familiar with this approach.
With traditional forms of insurance there is a cost (the premium you pay) to insure that specified losses are covered. Insurance on investment returns works in a similar manner, and is often accomplished with the purchase of an annuity. With a fixed annuity (and things called immediate annuities and indexed annuities) your “cost” is that you forego higher returns in exchange for a guaranteed outcome.
With certain variable annuities, you are charged an annual expense in exchange for a specific guarantee about the amount of money you can withdraw in the future. These guarantees often go by the name of a “lifetime withdrawal benefit” or “guaranteed withdrawal benefit”.
There are also other options, like index CDs, which offer a way to participate in market gains without risking principal.
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