4 Strategies for Reducing Risk in Your Investment Portfolio
Whether you are an experienced investor or are new to the world of stocks and bonds, you’re far from alone if the current market conditions have you second-guessing your portfolio.
A recent survey from Bank of America has found that at 71%, the highest number of investors since 2008 expect further deterioration to occur before the global economy improves. However, as historic trends have shown us, many of the strongest market days have occurred immediately after major downswings. In the meantime, reexamining your investment strategy through the lens of your current risk tolerance can help minimize your short-term losses.
Remember: Every investment is inherently associated with some degree of risk. While it is impossible to entirely avoid risk when investing in the markets, using the following strategies can limit your exposure to certain factors and position you for success.
1. Priorities to Address Before Investing
One of the most effective ways to reduce your overall risk comes before you even start investing; it is essential to take inventory of your current financial situation and your long-term goals prior to entering the market.
Though tempting, investing your income as soon as it becomes available may not always be the best course of action. To illustrate, CNBC reports that most credit card companies charge an interest rate of about 17%. This represents a number 7% higher than the average return of the S&P 500 over the last 32 years. With this in mind, paying off any existing high-interest personal debt should be a priority before building a stock portfolio.
When it’s financially possible, aim to set aside a rainy day fund that can support you and any dependents for three months or more. In the event of an emergency or an unexpected change in your current living situation, having a safety net–and no existing debt–can help ensure that any potential short-term gain will not have a severe impact on your long-term finances and retirement plans.
2. Apply Dollar-Cost Averaging
The markets are in a state of constant flux. However, as Investopedia explains, most stocks tend to move in the same general direction, swept along by larger currents in the economy. Given this phenomenon, the best strategy to deploy when investing is a long-term one such as dollar-cost averaging.
Dollar-cost averaging is a long-term investing strategy that involves allocating a fixed sum of money to the same stock on a regular basis, regardless of the stock’s price at any given time. The number of shares purchased month-to-month will vary depending on the price of the stock on the purchase date. In the long run, dollar-cost averaging can be a highly strategic way to invest. Since an investor is buying more shares when the cost is low, they are able to reduce their average cost per share over time.
If you are relatively new to the world of investing, this strategy can be a useful way to begin building assets without a major or overwhelming commitment. With that being said, just as dollar-cost averaging can help you avoid below-average returns, it’ll limit your ability to achieve above-average returns as well. So, if you closely follow the equity markets or work with a financial advisor, dollar-cost averaging may not be the most effective tactic for you.
3. Diversify Across Market Caps, Regions, and Sectors
At its most basic, portfolio diversification consists of spreading investments out over different names and asset classes while maintaining a healthy balance of equity and fixed-income securities. This strategy can take many forms, so we will provide an overview of three common methods: caps, regions, and sectors.
Market capitalization refers to the total value of all publicly traded shares of a given company. It can be understood as a measure of an organization’s financial worth rather than its size based on its number of employees. Generally, large-cap companies (corporations) tend to have more stable stock prices which also come with slower growth and less risk of a collapse. Comparatively, small-cap companies (smaller businesses) have room to grow and can rise in value quickly, but by the same token, the value of this group can fall just as fast.
By spreading your money across small-, mid-, and large-cap index funds, you can balance the growth potential of small-cap companies with the stability afforded by large-cap companies.
Like market caps, diversifying across different geographic regions and countries comes with similar risks and considerations. Advanced economies, such as those in the Group of Seven (G7), tend to grow more slowly, however they introduce far less risk to your portfolio. Emerging markets, such as Brazil and Vietnam, offer room for growth, but political instability and unfavorable currency fluctuations can quickly lead to a financial crisis.
Currently, the Vanguard Total World Stock Index is weighted about 60% in the United States and 40% foreign.
Similar to how different market caps and regions offer faster potential growth or losses, certain sectors tend toward higher risk and returns than others. For example, U.S. News & World Report shows that the energy sector has risen 27.9% this year, whereas many of the most well-known players in the technology industry are down 90% or more after peaking in 2021.
Looking across the 11 sectors as defined by the S&P, investors should strive to allocate funding toward a mixture of stable and high-growth industries. The former includes companies such as those that provide utilities or health care, whereas technology sits firmly in the latter.
4. Partner With a Fee-Only Financial Advisor
The prospect of keeping track of all of your investments while staying up-to-date with the latest trends in the market can overwhelm even the most experienced investor. Working with a financial advisor can help you navigate the stock market and move forward with confidence regardless of these changes.
As your advisor, we will work with you to create a long-term strategy consistent with your goals—one that not only aligns with your risk tolerance, liquidity needs, and timeline for retirement—but also includes strategies like the ones outlined above to minimize any potential losses. Because we are fee-only, we never benefit from commissions on the investments we recommend.
If you are interested in working with us, or have any additional questions about reducing risk in your portfolio, reach out to us today to book a free, no-obligation consultation, including a portfolio risk assessment.
By partnering with us, we can help you achieve your goals and peace of mind