Reduce Portfolio Risk—Diversify

Diversification techniques to mitigate downside portfolio risk

Navigating through the "What-Ifs" and Uncertainties of portfolio performance can be a bit of a balancing act...

If you are like most investors, whether experienced or not, you have more than likely concerned yourself with the “what-ifs” and uncertainties of the performance of your investment portfolio. Although there are many techniques that people use to hedge the under-performance of an investment portfolio, maintaining a well-diversified portfolio in order to reduce the downside risk is rather important and can help to reduce the impact.

Types of Risk to Look Out For

There are several different types of risk that investors should be aware of before investing in certain funds ─ specifically, systematic and unsystematic risk. Systematic risk is non-diversifiable meaning that as much as the portfolio is diversified, the risk cannot totally be eliminated. Some types of non-diversifiable risks include; inflation, interest rates, and reinvestment rate risk, all of which are out of the control of the investor.

Conversely, unsystematic risk is diversifiable. Examples of diversifiable risks include; business risk, financial risk, default risk and political risk. Diversifiable risks are classified as such because they can generally be unique to a single security, business, or country. For instance, in default risk, bonds that are issued by corporations and municipalities have ratings that indicate their likelihood of defaulting. Therefore, investors should include higher rated bonds in order to decrease the level of risk in an investment portfolio.

How to Determine Which Investments are Right For You

It is important to carefully consider the right mix of stocks, bonds, and other types of investments to include in your portfolio. The most efficient way to determine which investments are right for you is to first complete a risk tolerance questionnaire (see link below). Your resulting “risk-score” will help you to determine the level of risk that you are comfortable taking and paints a picture of what your investment portfolio should look like.

Traditional recommendations have encouraged younger investors to take substantial amounts of risk while middle to older-aged people are encouraged not to take risks. Industry statistics have shown that as you age, less money should be invested in the stock market and more in bonds and money market accounts due to the levels of volatility in bonds and money market accounts being less than the stock market. Risk can be divided into financial capacity and actual risk tolerance. They are both important components of risk management.

Steps for Reducing Portfolio Risk

There are several ways to help reduce risk in a portfolio and some may work better than others depending on the current situation of the market. Purchasing bonds or exchange-traded funds (ETFs) with low expense ratios may help reduce risk. Opening a self-directed IRA may reduce risk as well because it provides an option to invest in a wide array of investments such as, real-estate and commodities ─ all while keeping a tax advantage. Another way to help reduce risk is to purchase a protective put option for any broad market index represented in your portfolio. The put option will allow you to sell a security at a given price that it is set to be exercised within a certain time period. There is a cost to do this and the strategy may not work out for you as planned.

These are just a few examples of ways to reduce portfolio risk keeping in mind that individual portfolios may benefit from something different.

References:

Kaplan Financial Education. (2018). CFP Exam: Exam Prep Review. In Investment Planning (pp. 52-56). Kaplan Financial Education.

Stephens, C. (2017, December 19). 8 Ways to Lower Your Stock Market Risk in Retirement. Retrieved from U.S. News Money: https://money.usnews.com/money/blogs/on-retirement/articles/2017-12-19/8-ways-to-lower-your-stock-market-risk-in-retirement


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