Investing: Risk Mitigation

In our last article, we talked about how investing had many different types of risk. Even though the prospect of gaining something and having your money grow is exciting, we need to make sure we’re not looking through rose-colored glasses at our investments. Is there a way to avoid making common investing mistakes, or mitigating the amount of risk we’ll need to be concerned with? The strategies below will hopefully help you stay on the winning side of the market more often than not.

Strategy 1: Asset allocation
This strategy makes you first focus on how you where you want to put your money, and how much of it you want to put in each category. For example, if your goal is to get as much growth as possible, and don’t mind things being a little less safe, focusing on stocks over bonds would align with that goal. Below are the three main types of investments you can put your money into, along with a description of their strengths and weaknesses.

Stocks

• Can carry a high level of market risk over the short term due to fluctuating markets
• Historically earn higher long-term returns than other asset classes
• Generally outpace inflation better than most other investments over the long term

Bonds

• Generally have less severe short-term price fluctuations than stocks and therefore offer lower market risk
• Can preserve principal and tend to provide lower long-term returns and have higher inflation risks over time
• Bond prices are likely to fall when interest rates rise (if you sell a bond before it matures, you may get a higher or lower price than you paid, depending on the direction of interest rates)

Money market instruments

• Among the most stable of all asset classes in terms of returns, money market instruments carry low market risk (managers of these securities try to keep the per-share price at $1 and distribute returns as dividends)
• Generally don’t have the potential to outpace inflation by a large margin
• Not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency (there’s no guarantee that any fund will maintain a stable $1 share price)
  Different asset classes offer varying levels of potential return and market risk. For example, unlike stocks and corporate bonds, government T-bills offer guaranteed principal and interest — although money market funds that invest in them do not. As with any security, past performance doesn’t necessarily indicate future results. And asset allocation does not guarantee a profit.

Strategy 2: Portfolio diversification

This strategy focuses on making sure everything is split into different places. In the same way you might put a spare key somewhere separate from where you normally put your keys, you want to have your money in different places just in case. While this does not completely eliminate risk, it helps to make sure that whatever negative circumstances pop up won’t hit you hard and knock you over.

Strategy 3: Dollar-cost averaging

Dollar-cost averaging is a disciplined investment strategy that can help smooth out the effects of market fluctuations in your portfolio.
With this approach, you apply a specific dollar amount toward the purchase of stocks, bonds and/or mutual funds on a regular basis. As a result, you purchase more shares when prices are low and fewer shares when prices are high. Over time, the average cost of your shares will usually be lower than the average price of those shares. And because this strategy is systematic, it can help you avoid making emotional investment decisions.

These three examples help to put you in the driver seat when it comes to dealing with risks; make sure to be familiar with these strategies so you can apply the appropriate one as each situation arises.