[In layman’s terms] How to reduce risk to meet your goal

🌰In a nutshell: Your portfolio returns grow in proportion to your capital. That means a critical loss to your capital can slow down your total return by a significant measure. Therefore, minimizing your loss is as important as maximizing return to maintain a steady portfolio growth to meet your investment goal.

Today, we are going to take a look at the importance of reducing risk in order to meet your financial goal within a given time frame.

Greater loss needs even greater recovery

Let’s take a look at the following graph. The information was taken from bogleheads.org.

The following shows gain and loss in percentage. What it shows is the following.

What you can see is that as your loss is getting greater, the percentage you need to recover will become even greater.

For instance, if your loss is about 10%, you only need to recover 11% of what is left after the loss to recover.

However, when your loss is about 30%, you would need to recover 43% of the remaining balance. If you lose 50% of your initial value, you need to recover 100% of what’s left in your account to strike an even. This means, you need to double the balance to recover the initial value.

This is actually obvious. If you originally started at 100 and lost 50, then you would have only 50. In order to recover 100, you would need to recover 50, which is doubling your balance.

percent gain and loss and its relationships with recovery time

Achieving 100% performance is quite a daunting task even in a bull market. In fact, it may take you a while to recover your starting point. It is not hard to imagine why this can really put behind your investment schedule. As such, building a portfolio with high tolerance to risk is just as important, if not more, as building a portfolio with a potentially high return. This becomes even more essential when the market is highly volatile and unpredictable, such as the crypto market. Therefore, you would need to do something to manage the magnitude of any loss in order to stay on track of meeting your financial goal.

Six strategies to reduce investment risk

Now that we understand how important it is to manage losses, what are the options we can take to manage the risk?

Here are six strategies that you can use to mitigate risks in the unpredictable and volatile asset markets.

  1. Use a stop-loss order on exchange-traded investments.
    This is a method to help protect your assets from sudden falls. When you place a stop-loss order, your exchange-trades shares will be automatically sold when the preset condition is met. This could be a certain price or a percent loss from your peak. (what is peak and trough)
  2. Invest in pooled funds.
    Investing in pooled funds is a way of diversifying your portfolio. We spoke briefly about index funds (The $1 Million Bet? Active Investment vs Passive Investment)The key is to have the funds follow the performance of a given index by mirroring the asset composition and weights. The idea is great, however, it is difficult for an individual to do so for very obvious reasons. First, you would need a lot of money to have every asset included in the index in their appropriate weights. Also, you would need to constantly rebalance the funds in order to have it reflect the index. As this is a difficult feat to achieve by individual traders, exchanges offer pooled funds. As an individual investor, you simply invest in the pooled fund of your choice, and your money is divided up between those assets in their due weights.

     

  3. Consider a wide asset allocation.
    How about spreading your investment into a variety of assets including cash, treasury bonds, pooled funds, ETFs, high yield bonds, individual stocks, and gold? These assets behave differently to changes that can affect market conditions, such as the increase or decrease of interest rates, foreign exchange rates, and so on. You can choose the level of risk you are comfortable in by adjusting the weight you invest in each class. However, assets with greater returns often carry a higher level of risk.

     

  4. Focus on your long-term plan.
    While there is no guarantee, staying invested over the long-term, preferably five years and longer gives a better chance of having positive returns on your portfolio. This will most likely be true in the case of a long run of a bull market. It is recommended not to monitor your portfolio too closely as you may be prompted to react if there is a sudden setback in value and sell at a loss. With the long-term plan, you may want to monitor the performance once or twice a year.

     

  5. Expand the geographic boundaries and invest globally.
    You can expand the concept of diversification to include assets and stocks from different regions of the world. Global funds may invest in companies in both developed and emerging markets. If you do not limit your portfolio to just assets from one region, the USA for example, and include stocks from other parts of the regions, you may be able to build a portfolio that has greater tolerance to country risks from the US.

     

  6. Consider regular investments.
    There is a concept called “dollar cost averaging”. Let’s suppose you are buying a total of 100 shares of a company’s stock. Instead of buying the entire 100 shares at once, you could buy them over time: more shares when the price is low, fewer shares when the price is high. In theory, the strategy is to smooth out volatility over time. However, in the case of a prolonged bull market, it may be to your advantage to buy at a lump sum and hold them for the entire period.

As you can see, we have spoken a good deal on the idea of diversification. Up next, let’s talk about the concept of diversification and risk in detail.

Until then, how about checking your portfolio for free to see if your strategy is within the risk tolerance level you have originally designed!

References

“Percentage Gain And Loss – Bogleheads”. Bogleheads.Org, 2020, https://www.bogleheads.org/wiki/Percentage_gain_and_loss#cite_note-1.

“Six Strategies To Reduce Investment Risk | Barclays Smart Investor”. Barclays.Co.Uk, 2020, https://www.barclays.co.uk/smart-investor/news-and-research/investment-strategies/six-strategies-to-reduce-investment-risk/. Accessed 3 Mar 2020.

Check to manage your risk for free!

Check your crypto portfolio for its risk vs. rewards, and how they compare to other benchmark assets! 

Share:

Popular Post

Get early access to the latest updates on the MoA Investment Solutions