Mitigating risk in your portfolio helps reduce your losses when markets start to fluctuate. There are several strategies to mitigate risk, including portfolio diversification, dollar-cost averaging, avoiding herd mentality, maintaining liquidity, and applying a long-term outlook.
Portfolio Diversification
Diversification involves dividing the asset classes in your portfolio, selecting a variety of stocks in different industries, and/or investing in different geographical regions. Depending on your financial goals, you should invest in a mixture of stocks, bonds, and money market instruments to lessen the impact of major market fluctuations. For example, if your financial goals are to pursue growth, you may invest 80% in stocks and just 20% in bonds, which still provides some diversification.
Furthermore, holding 30 stocks compared to 10 can diversify away from company-specific risk and offer more stability in the event of fluctuations. However, only investing in these stocks and not other asset classes does not help to diversify the systematic risk associated with large or small-cap stocks.
Diversification can also be achieved by investing in different industries and countries, where losses in one area are offset with gains in another.
Dollar-cost Averaging
This strategy involves investing a specific amount towards the purchase of stocks, bonds or other assets on a regular basis. By setting a strict schedule to invest, you will end up purchasing more shares when prices are low and fewer when prices are high. Due to the systematic nature of this strategy, you can avoid making emotional investment decisions that often lead to losses.
Avoid Following the Herd
Maintaining a long-term outlook and avoiding responding to short-term events can help reduce portfolio risk. Often, investors get spooked by negative economic news that causes other investors to sell. Following suit, they sell as well, causing a major correction in the market. Instead of following the herd, try to stay on course and wait for prices to recover.
Maintain Liquidity
Keeping 3-12 months of expenses accessible in cash and other liquid asset classes provides a cushion to prepare for poor outcomes. This liquid cushion allows your higher volatility assets to produce long-term returns, while providing cash for when you are going through a down cycle.
Don’t Try to Time the Market
Due to the unpredictable nature of the stock market, it is impossible to make educated guesses as to when is the best time to sell and buy. Instead of trying to time the market, maintain a long-term approach in order to build wealth.
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