7 Ways to Reduce Financial Risk
Dear Rich Lifer,
Before the days of the Internet, surfers would use weather reports and tide charts to forecast the surf.
But in most cases, you’d find waves by simply strapping a surfboard on your car and driving to the beach.
If there were waves, you surfed. If it was flat, you went home.
Nowadays, a quick Google search will tell me wave heights, wind direction, swell direction and tide.
So, I laugh when I hear people say that surfing is a risky sport.
Because with a little due diligence, you can eliminate most, if not all, the risk before leaving your house.
The same can be said for your investments.
Every investment you own carries inherent risk. Even holding cash exposes you to inflation.
But like modern surf reports, there are strategies and tools you can use to help mitigate a lot of the upfront risk.
Here are seven of my favorite ways to reduce investment risk, in no particular order.
This should be obvious, but keeping all your eggs in one basket is a risky bet. In market downturns, well-diversified portfolios tend to outperform concentrated ones.
The deeper and more broadly diversified your portfolio, the better your chances of mitigating the risk. I’ll leave it at that since diversifying is an entire topic for another day.
When you invest in the markets generally, there’s systematic risk. One way to reduce this risk is by adding non-correlating asset classes like bonds, currencies, commodities, and real estate to your portfolio.
Non-correlating assets typically move in inverse ways compared to stocks in the market. The advantage here is when one asset class is down, another is usually up. This helps smooth out the volatility of your total portfolio.
I’ve talked about put options in previous issues. Essentially you’re placing a bet that a stock will go down in price at a future date.
This is different from shorting the stock, the put gives you the option to sell at a certain price at a specific point in the future.
For example, let’s assume you own 100 shares of Company Y, which has risen by 70% in a single year and now trades at $100. You think that it has a bright future but the stock has risen too quickly and is likely going to drop in value soon.
To protect your profits, you buy one put option of Company Y with an expiration date four months in the future at a strike price of $105, or slightly in the money.
The cost to buy this option is $600 or $6 per share, which gives you the right to sell 100 shares of Company Y at $105 sometime before its expiry in four months.
If the stock drops to $90, the cost to buy the put option will have risen significantly. At this point, you sell the option for a profit to offset the decline in the stock price.
Another way to reduce the risk of falling share prices are stop loss orders. These come in many forms but you typically have two kinds: hard stops and trailing stops.
Hard stops trigger the sale of a stock at a fixed price that doesn’t change. For example, if you buy Company Y’s stock for $10 per share with a hard stop at $9, the stock is automatically sold if the price drops to $9.
Trailing stops move with the stock price and can be set in dollars or percentages.
For example, if a trade is entered at $30, a 10 cent trailing stop would be placed at $29.90. If the price then moved up to $30.10, the trailing stop would move to $30. At $30.20, the trailing stop would move to $30.10.
If the price then moved back down to $30.15, the trailing stop would stay at $30.10. If the price continued down and reached $30.10, the trailing stop would exit the trade at $30.10, having protected ten cents of profit (per share).
Studies show that companies who pay generous dividends tend to grow earnings faster than those that don’t.
Faster growth usually leads to higher share prices which generates higher capital gains. How does this reduce risk?
Basically, by increasing your overall return.
If stock prices fall, you have the cushion dividends provide. Plus, dividends are a good hedge against inflation, which makes them an attractive investment choice for retirees trying to keep pace with inflation.
If market fluctuations turn you into an emotional wreck, then this strategy should help.
With dollar-cost averaging, you apply a specific dollar amount toward the purchase of stocks, bonds or mutual funds on a regular basis.
As a result, you end up buying more shares when prices are low and fewer shares when prices are high. And over time, the average cost of your shares usually is lower than the average price of those shares.
Why I like this strategy is because it can easily be automated, removing any emotional decision making.
This should go without saying but do your research before you invest. Look at the investment’s history, earnings growth, management team and debt load.
You should be comparing similar investments as well as other assets in your portfolio. One key metric to look at is a stock’s price-to-earnings ratio. P/E ratio measures the relationship between a company’s stock price and its annual after-tax earnings.
If your research tells you a company has a higher P/E ratio compared to other companies in the same industry, you could be looking at a high risk investment.
By weeding out companies with high P/E ratios, unstable management and inconsistent earnings and sales growth, you reduce a lot of uncertainty.
These are just some of the different ways you can mitigate investment risk. There’s no secret formula that will erase all risk, but you can certainly lower your exposure to a level that you’ll sleep better at night.
To a richer life,