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By investing in the markets, you actively take on risk that rewards you a return when markets go up. But by taking on risk, you also inevitably expose your investments to a potential downside when markets go down. If you’re taking on more risk than you’re comfortable with, you may be one of the investors who is more susceptible to making harmful investment decisions in the short term that compromise your long-term financial goals.
Managing your risk is about how you set up and manage your investments, and doing that properly is a key to successful investing. Here are some ways you could be exposing your investments to unnecessary risks and how you can manage those risks.
Let’s say you’ve invested most of your savings in the stock market. If an unexpected event caused the stock market to crash, you could lose a significant portion of your net worth, and as a result, jeopardise your financial well-being. Having most of your net worth in a single asset type is called concentration risk, and it refers to the fact that you unnecessarily risk losing money in a single event.
This concentration risk can be reduced by diversifying your investments. Diversifying your investment portfolio allows you to still reap the return from holding riskier assets in your portfolio while minimising the negative impacts a single asset, or asset class can have on your investments. For example, a portfolio with a mix of equities, bonds and commodities earns a return from the risky part of the portfolio (equities) while the protective assets (bonds, and gold) minimise your downside in the event of a market downturn. In addition, a portfolio that’s also diversified in global asset classes provides opportunities to earn a return from high-growth economies while reducing the impact of event risks, such as political turmoil and natural disasters on your overall portfolio.
And, instead of concentrating all of your savings in a single portfolio, you can have different portfolios with different asset allocations depending on the time frame of your goals. For instance, you can choose to have a portfolio with a greater allocation to riskier assets if your goals have a longer time horizon. A higher-risk portfolio may experience short-term drawdowns but generate greater returns in the long run.
Often, market timers are driven by emotions, not sound investing principles and proper risk management. For instance, investors driven by the fear of missing out will buy too much as the markets rise and take on more risk than they can handle. But when markets inevitably go down, they’re unable to stomach the risk and start offloading their holdings at a loss.
Even if you’re level-headed and rational, it’s almost impossible to outperform the market by timing it. Consider that an investor who remained fully invested in the S&P 500 Index between 1995 and 2014 would have earned 9.85% per annum. But, if he missed only 10 days where the market rallied, the return would have been 5.1%.
Instead of going all-in as market timers often do, investing systematically, known as dollar-cost averaging (DCA), helps you avoid the risk of realising large losses that come with timing the market. By committing to invest in the market on a regular basis regardless of whether the markets go up or down, DCA spreads your risk exposure across multiple price points over time. Contrary to what market timers believe, there isn’t a wrong time to invest, as long as you don’t only invest once. With DCA, you buy more units when prices are lower and average into the market when the markets are going up, which minimises your investment risk overall.
Markets have historically gone up over the long-term so the most beneficial thing you can do for your investments is to stick to your long-term financial plan and stay invested. By staying invested, you give your investments the opportunity to compound effectively and reap a greater return in the long term.
You might be tempted to cash out when markets are declining hoping to buy back in at the bottom. But the reality is no one knows where the bottom is and by moving out of the markets, you risk losing out on potential gains that come when the markets go up. During the 2008 Financial Crisis, the S&P 500 bottomed on 9 March 2009 and went on to gain almost 65% by 31 December 2009. At the time, investors didn’t know that the recovery had started and even a year later, many of them still argued that it wasn’t the right time to enter the market. Had you held your investments in cash during that period, chances are you would have set up a psychological barrier to enter the markets and missed the opportunity to ride the market’s long-term upward momentum. Not to mention, holding your investments in cash guarantees that your money loses value over time.
All investing entails risk. Ultimately, when you understand and manage your risk through diversification, dollar-cost averaging and staying invested, your money will have the best chance to earn a return from the markets and help you reach your financial goals on time.