Controlling risk is key to your investment strategy. One of the best ways to manage risk is to spread your investments and savings across a variety of channels. This is important because if you have all — or even most — of your money in one place (whether it’s the stock market, real estate or even municipal bonds issued by your hometown), you’re at a higher risk to lose it all if something goes wrong.
There are three main ways to control risk: diversification, investing consistently and investing over a long period of time.
Diversification and Asset Allocation
A well-balanced investment portfolio involves spreading investment funds among different types of assets and investing in different securities within each type of asset. This reduces risk, because even though one or more investments might falter, others will gain.
When you think about it, it makes sense that diversification among different types of assets helps reduce risk.
Diversifying means spreading investments across different industry sectors (e.g., technology and health care) and securities (e.g., stocks and bonds), and using a variety of investment products to protect the value of your overall portfolio in case a single security or market sector takes a serious downturn.
Think of it this way: If all of your wealth was in a single company’s stock and that stock suddenly plummeted 50 percent, you would lose half of your savings. However, if your investments were spread out over several stocks, as well as real estate, bonds and other products, then the loss would not affect you nearly as much.
Risks and rewards of major asset classes
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
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)
Investing Consistently (Dollar-Cost Averaging)
One way to make the most of investments over time is to commit to investing a certain dollar amount on a regular basis. For example, let’s say you are going to invest $100 per month in Company XYZ’s stock. The value of the stock will fluctuate from month to month based on the company’s performance, the demand for the stock and other factors. Regardless of whether the stock is high or low, you buy as many shares of Company XYZ’s stock as you can with your $100.
One month, your $100 might buy you two shares, the next month it might buy just one share. But no matter what, you consistently invest your $100. This is called dollar-cost averaging.
Dollar-cost averaging means you invest a specific amount of money at a regular time interval (e.g., monthly or bi-weekly), regardless of what the market is doing. Sometimes you’ll buy high and sometimes you’ll buy low, but since markets generally rise over time, you’ll often do well over the long term.
Over the span of the whole six months, you were able to buy shares at a better price than the average. However, six months is not long enough to see real returns on stock market investments. In order to see real benefits of dollar-cost averaging, you ideally would hold your investments for 10 or 20 years or longer. That’s why it’s important to view investing in the stock market as a long-term savings and wealth-building tool, not a get-rich-quick tactic.
The key to dollar-cost averaging is to choose carefully which companies to invest in. This approach is best for buying stock in industries or companies that you expect to have sustained growth over time, rather than risky startup companies – unless you are willing to take on higher risk.
Investing Over Time
Research shows that investing for the very long term reduces investment risk because, even though the price of a given investment may rise and fall within a short period of time, it generally will gain back any losses over the long term. Investing is a long-term strategy for long-term goals (typically five, 10, 20 years or even longer).
Withstanding short-term price fluctuations often generates greater long-term rewards for stocks versus other asset classes. Stocks fluctuate in value more than CDs, so you can lose part or even all of your investment in a short period of time. Yet, over the long term, stocks, on average, consistently and substantially outperform cash and the killer of cash: inflation.
Article partially published on smartaboutmoney.org
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