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Managing Investment Risk

Risk is different from mere uncertainty. It is possible to analyze the risks inherent in an investment, and manage them in such a way as to increase your likelihood of returns and decrease your chance of losses. By strategically managing investment risk, you can take advantage of the higher return potential of higher risk investments.

The most common risk management strategy is diversification.

The most common risk management strategy is diversification: combining investments in different kinds of assets into one portfolio, so that no one set of economic or market factors will have too great an impact on the overall value of your investments. For example, if you invested all of your capital in petroleum stocks, a drop in gasoline prices could have a devastating effect on your portfolio. However, if you combined your petroleum stocks with investments in an industry that would benefit from a drop in gasoline prices—automobile manufacturing, for instance—the rise in one stock would offset the drop in the other. The heart of Modern Portfolio Theory is to manage the risk-return relationship of a portfolio so that it gets the maximum return for the risk it accepts, and so that it accepts as little risk as possible to achieve a given return.

One of the most effective diversification techniques is asset allocation: apportioning your investment capital among different asset classes (stocks, bonds, cash equivalents, etc). Research has shown that the way a portfolio is divided among asset classes is a better predictor of how well it will perform than which individual stocks or bonds are included. Using asset allocation, you place a portion of your capital in more aggressive investments, like stocks, and another portion in safer instruments like bonds.

Finally, understanding your investment time horizon can help you increase your risk tolerance in the short term. Holding riskier investments for longer periods of time generally helps you overcome short-term drops in value. The stock market is a good example: even despite disastrous crashes, stockholders who keep their holdings long-term have seen greater gains than those who relied on "safer" investments such as bonds. If your investment goals allow you to hold your investments for long periods, you can benefit by pursuing a more aggressive investment strategy.