The old saying “it takes money to make money” is true when it comes to growing your wealth. While Investment can be a very profitable strategy for Wealth Growth, it comes with a lot of intrinsic risks.
Most likely you know at least a handful of people who lost money in real estate or the stock market. I was one of these people. I invested in real estate without doing my due diligence and lost… I invested 100% of my 401K funds in the stock of the company I was working for at the time (Morgan Stanley) and was doing great until the market crashed in 2008-2009.
I was shocked and really frustrated by my lack of discipline! Since that time I implemented many risk strategies and became very successful with my investment endeavors. I’ve learned my lessons the hard way but you don’t have to. That is why I want to share with you some of the most important Risk Management strategies I know and use.
Investment Risk Management strategies
The most important question to ask when considering any investment opportunity is, “How much money can I lose?” Being a successful investor requires patience and caution. Since I am not naturally wired with these faculties, I have to make a conscious effort to pause and ask myself these risk management questions:
- How much can I lose if things do not work out as I hope?
- How can I minimize the amount of loss?
Asking these questions gives me time to contemplate risk management tactics and helps get my emotions out of the way. Once I take care of the potential risk, then I can focus on the fun part—making money!
Most people who are new to investing are focused on the potential upside, chasing the latest hot opportunity. They are not inclined to think about what would happen if the best-case scenario doesn’t happen (and it rarely does). Every person has a different risk tolerance, but investors who employ prudent risk management strategies usually enjoy steady wealth growth and experience much less worry and stress.
Longer Term Investment Timeline Decreases Risk
Trading does not equate to investing. There are a lot of day-traders—people who trade in-and-out within few days by taking advantage of short-term market fluctuations. Very few short-term or day traders have acquired great wealth.
Investing, on the other hand, has a much longer time horizon and most asset classes—stocks, real estate, commodities—appreciate over a longer period of time. This is one more reason to research your investment choices very thoroughly and apply simple risk management approaches.
Furthermore, there are times when sitting tight/doing nothing is the best solution—don’t feel pressured to always buy or sell. It’s not the frequency of investing but rather the quality of your decisions over time that adds up to great wealth. Learn when to act and when to wait.
Asset Allocation and Diversification As Risk Management
Prudent investing is about reducing risk first. Next it is about managing profits. Nobody can be right all the time, and a disciplined attitude coupled with fundamental risk management are essential. Taking on more risk often leaves you feeling broke instead of wealthy.
Asset allocation is an investment strategy that helps balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to your risk tolerance, goals and investment timeline.
Asset allocation is based on the principle that different assets, not perfectly correlated, perform differently in different economic and market conditions. For example, a conservative portfolio may contain the following asset allocation: 40 percent corporate bonds, 10 percent treasury notes, 20 percent cash, 20 percent precious metals, 10 percent stocks. In contrast, aggressive portfolio may have 100 percent of its funds invested in stocks….
Diversifying your savings among different asset classes (cash, bonds, precious metals, etc.) decreases your risk of massive losses. Diversification as a risk management tool is extremely important for choosing the actual investment vehicles.
NEVER…EVER put all or even most of your money in any one particular investment.
If your employer offers you shares of common stock of the company as a form of retirement contribution in addition to your own retirement contributions (a good idea since your contribution is tax free), find out how you can diversify all retirement money among different investment vehicles.
Position Sizing Helps Prevent Big Losses
Keeping the discipline of putting no more than 5 percent of your portfolio in one particular position helps avoid significant losses in your asset portfolio. This applies to any asset class.
Imagine putting all of your retirement savings into stock issued by the company where you work…and then watching the stock decline due to conditions beyond the company’s control. This imaginary scenario became a reality for a lot of employees during past stock market meltdowns and individual companies’ stocks crashes.
Another investment mistake that pertains to position sizing is price leveraging. Let’s say you purchased 500 shares of a company “Z” at $50/share. Then the stock price falls to $30/share and you decide to buy another 500. Your average cost per share of stock now is $40 and you own 1,000 shares.
In one week the stock “Z” falls further, to $10/share. You decide to take advantage of yet another bargain and buy 1,000 shares more, so your average cost per share becomes $25. It is highly possible that the stock price will continue sliding and you may end up with a disproportionately high amount of bad investment….
I emphasize the importance of having discipline about position sizing and diversification so that you will never end up with disproportionately high amount of bad investments. Greed and emotions are worth enemies when it comes to investment.
I will continue sharing with you about other risk management strategies next week.
To Your Health, Wealth and Freedom!
With Love and Gratitude,