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Investing in assets is an important part of anyone’s financial plan.
Without investments, you would lose money every year due to inflation, and you wouldn’t be able to achieve financial freedom.
But did you know that investing also comes with risk? Are you aware of all the risks you’re taking on before you invest your hard-earned money?
I’m going to share with you 8 different investment risks and also teach you 3 simple ways you can reduce risk in investing.
To be a successful investor, you need to understand different risks and how to reduce them, so I hope you’re paying close attention!
What type of investment risk is there?
There are a total of 8 different types of investment risk I want to go over.
A smart investor will keep in mind these risks when choosing his/her investment strategies.
Afterwards, I will go over the 3 simple tips you can implement to reduce risk in investing.
You must properly understand the types of risk to get a better grasp on how the 3 tips will work.
Market Risk
The first type of risk your portfolio may experience is market risk.
Macro Economics
The value of your investments may decrease due to changes in the economy.
When the FED raises interest rates, the stock market usually falls. Higher interest rates mean fewer people would be out spending money, and more people would be saving than investing. Inexperienced investors also frequently tend to sell out of their stocks and keep their money in cash.
Volatility
Stocks are volatile. No one can consistently predict where the prices of stocks are going to go. For example, starting from November 2021, both Netflix’s stock and Meta’s stock dropped more than 75%!
Do you think you’d be able to make those predictions? I certainly wouldn’t. As big as those companies are, I never would’ve guessed their stocks would drop so much.
Risk of Default
Some stocks may also go out of business, causing their share price to go to $0.
Take General Motors as an example. Back in 2008, they were one of the largest companies with the highest revenue out of any company in the United States. They had a bright future ahead but ended up going bankrupt.
If you were to invest in a company that went bankrupt, you would lose the money you invested.
Investing in foreign countries, especially securities from emerging markets, are usually seen as riskier compared to U.S. investments.
(Emerging markets refer to foreign developing countries such as Brazil, Saudi Arabia, and India)
Emerging markets are seen as having less stable governments which translate to more risk. You never know what may happen economically to a country with an unstable government.
They also come with currency risk, because you’re investing in countries that don’t use the U.S. dollar.
Inflation Risk
On average, inflation rate has been 3.8% every year in the U.S.
What does that mean for you? It means that for every dollar you keep in cash, you are losing 3.8% of purchasing power every single year.
Also, occasionally inflation may get out of control and your investments may underperform. This is especially true if you are invested in any bonds, bond index funds, or cash equivalents such as a certificate of deposit. These investments have a lower return.
Interest Rate Risk
As I mentioned earlier, the stock market usually falls when the FED raises interest rates.
But the stock market is not the only thing that falls.
If you are invested in any bonds, those bonds will decrease in value as well.
When the FED raises interest rates, the interest rate on newly issued bonds also goes up. Therefore, older bonds with lower interest rates becomes less valuable.
Liquidity Risk
In the world of investing, “liquidity” is a measurement of how easily you can convert your investments to cash without affecting their value.
High Liquidity
If an investment has “high liquidity,” it means it can easily be converted to cash.
For example, Tesla’s stock is very liquid because it’s popular and many people trade it on a daily basis. It would be easy for you to buy and sell shares in Tesla because someone would always be on the other end. Transactions would occur instantaneously without affecting the value of your shares.
Low Liquidity
If an investment has “low liquidity,” it would be more difficult to convert to cash and may negatively affect the value of your investments.
An example of something with low liquidity can be something like a stock with extremely low volume. If you want to sell your shares, but no one will buy them from you, you cannot sell! It might take you days to be able to sell your shares, and by then, the price of the share may have already dropped.
Another example would be a certificate of deposit. You can’t convert to cash before the term finishes without incurring a penalty fee.
Concentration Risk
Concentration risk is the risk of not having enough diversification.
For example, if you’ve invested in stocks only in the technology sector, and that sector takes a hit, all of your investments are going to be affected.
If the financial sector starts going up because of some economic factor, your investments wouldn’t experience this growth because you’re so concentrated in technology.
Horizon Risk
This may occur if your investment timeline is unexpectedly shortened.
For example, you may have to sell your investments if you have to pay some emergency medical bills you were never expecting. Selling early may mean you sell at a loss.
Longevity Risk
Longevity risk occurs when you outlive your investments. You may not have invested enough throughout your lifetime to sustain your lifestyle into your senior years.
Credit Risk
Businesses use money from bonds and selling stock shares to fund new projects.
But what happens if these projects fail, and the company goes bankrupt? You run the risk of not being able to get your money back.
Introduction to Reducing Risk: Diversification
First of all, you need to understand what diversification is and why you should even care about it.
Let’s take Amazon as an example.
Everyone knows about this huge e-commerce company. But do you know how they reduce risk when doing business?
Think of all the things that Amazon sells. They sell products, music, e-books, and subscription services, and even offer credit cards.
Amazon, along with any other big business, doesn’t do this by accident. They do this to diversify, and not to only rely on one source of income.
For example, what would happen if they only sold e-books, and their sales drops all of a sudden? They would lose all their revenue.
Diversifying their sources of income allows them to reduce risk. If their sales of products and e-books drop, they can still rely on subscription services. If people start unsubscribing from their services, they can still rely on selling other products.
Pretty smart, huh?
Diversification doesn’t only apply to big businesses, but also your investments.
You need to learn how to decrease investment risk to maximize your returns, and you do that by diversifying.
Don’t put “all your eggs in one basket,” but spread them out.
How do I reduce risk in investing?
Understand Risk vs Reward
Risk and reward always come hand-in-hand.
If you want to achieve higher returns, you’ll have to take on more risk.
On the other hand, if you don’t want to take on too much risk, you’ll have to settle for lower returns.
There is no other way around this.
Usually, you can take on more risk if you’re younger. This is because you have more time until retirement. If you incur a loss, you have more time to recoup and get back on track.
If you’re closer to retirement, taking on too much risk may jeopardize your retirement. If you’re invested too heavily in stocks, and the market makes a downturn, you may not have enough capital to retire when you wanted to.
Retirement isn’t the only reason why people would take on less risk. Some people just don’t handle risk well. Those people would be better off taking on less risk with their investments.
Determine your Asset Allocation
An “asset allocation” is defined by how much of your money you invest in different asset classes such as stocks and bonds.
For example, if you invest 80% of your money in stocks and 20% of your money in bonds, you have a stock/bond asset allocation of 80/20.
Your asset allocation is a personal decision – there is no “one-size-fits-all” because everyone is different.
However, allocating your money to different assets is important because they react differently under different market conditions.
For example, could you handle seeing your portfolio lose 57% of its value? Well, back in 2008, the stock market dropped by 57% due to the financial crisis. In other words, if you had $10,000 invested in stocks at that time, that money would’ve dropped to $4,300.
Portfolio Visualizer is a great tool you can use to test out different asset allocations. Play around with the tool and see how you would feel about holding different stock/bond allocations. See my step-by-step tutorial on how to use this tool.
Keep in mind, no one can predict when certain asset classes will outperform others, so you’re better off just spreading across different assets.
Let’s take a look at three different asset classes: stocks, bonds, and cash.
Stocks
Stocks yield the highest out of the three. The S&P 500, which is the top 500 stocks in the United States, averages around 10% annually.
Smaller stocks can grow at a faster rate, but they are not as well established and have a higher risk of going bankrupt. Therefore, they’re high-risk high-reward.
Larger stocks grow slower but they’re less risky because they’re well-established businesses.
Bonds
Bonds yield lower than stocks, but they’re more stable and less risky.
They usually payout a fixed interest rate at the end of every month, which is predictable and stable.
People usually allocate more to bonds when they get closer to retirement. This is to protect the capital they’ve built up throughout their lifetime.
Bonds can also be used as a tool to dampen volatility for those who don’t like taking on too much risk. The stock market is a volatile investment and adding bonds to your portfolio will decrease volatility.
But keep in mind – the more bonds, the less volatile your portfolio will be, but you’ll have to settle for less returns.
Some bonds can yield similar to stocks, but those are called, “junk bonds,” and they have a higher risk of default.
Cash or Cash Equivalents
Some examples of cash equivalents are certificates of deposits, Treasury Bills (T-Bills), and money market accounts.
These yield the lowest and are the safest because the U.S. government guarantees the majority of these types of investments.
The main risk with these is inflation. Because they yield so low, inflation would eat up your returns and you would lose purchasing power.
Further Diversify Between Assets
Diversification is taking asset allocation a step further.
Imagine only having one stock and one bond in your investment portfolio. That’s not diversified enough.
You must have different types of stocks and bonds from different sectors.
For example, Apple and Amazon are both great companies, but they’re from different sectors. Apple is from the technology sector, while Amazon is from consumer cyclical.
If your investments were all concentrated in tech stocks and the tech sector takes a hit, all of your investments are going to be negatively affected.
What if, while the tech sector takes a hit, the financial sector sees a major boom in growth?
You never know what may happen in investing. That’s why diversification is so important.
Index Funds
So how do you achieve proper diversification? How do you know which stocks and bonds to invest in without being too concentrated?
Simple answer: index funds.
Investing in index funds is the most passive way to build diversification throughout multiple sectors without the hassle. They are like a basket full of different stocks that act as one single investment.
If you wanted to invest in the top companies in the United States, all you would have to do is invest in an S&P 500 index fund.
Allow me to explain.
Imagine that you want to buy all different types of candies. Rather than spending hours at the store, trying to shuffle through hundreds of different types of candies, all you would have to do is buy a goodie basket.
The same concept applies to index funds. An index fund is like a basket of many different stocks that acts as a single investment.
Instead of going out and buying all 500 companies, simply buy the basket, or the index fund, and you’ll achieve the same effect. The fund manager does all the picking, while all you have to do is invest your money, sit back, and relax.
What’s the catch? Well, index funds charge a small fee called an “expense ratio.” Because index funds are passively managed to match their benchmark, the expense ratios on index funds are extremely low.
Index fund expense ratios can range anywhere from 0.015% – 0.03% per year. In other words, if you were being charged 0.03% per year, you would only have to pay $3 for every $10,000 you invest!
Stock Index Funds
Here are some of the top S&P 500 index funds you can invest in:
Read More >> My full “free” guide on index fund investing!
Bond Index Funds
The same goes for bonds. Instead of investing in one single bond, you should diversify into many different bonds.
You can easily do this with bond index funds.
Here are some popular bond index funds from the same companies:
The 3-fund Portfolio
The 3-fund portfolio is one of the simplest investment strategies you’ll find out there.
It’s a strategy that takes into account all the information outlined in this article and keeps it simple by only using three funds. Anyone can get started and be successful with zero experience!
Check out the article now!
Conclusion
Reducing risk in investing is an easy process once you understand the concepts involved.
All you have to do is understand risk vs. reward, choose your asset allocation and diversify between asset classes.
Diversifying between asset classes is easy because all you have to do is invest in index funds.
Stocks and bonds are not the only things you can invest in. Learn about other great assets you can invest to start building wealth.