How an Investor Can Reduce Risk
by SmallIvy
Investing by its nature involves taking on some degree of risk. Typically the potential for gain (the possible rate of return) is proportional to the amount of risk taken. For example, a bank account carries very little risk, thanks to programs like the Federal Deposit Insurance Corporation, and yet the potential return is usually less than inflation. Commodity futures on-the-other-hand can produce returns of several hundreds of percent each year, but the return is certainly far from assured and the risk of losing large amounts of money is substantial.
This article will focus on securities which are suitable for investment. Here investment is defined as buying assets where the odds of making money are substantially in the individual's favor. Commodity futures trading, trading stock options , and day trading stocks and other similar activities all fall within the realm of speculating – where the odds are even or against the individual – and therefore are not included.
In investing, the main sources of loss are the loss of spending power and the depreciation of assets. The former is caused by inflation which causes the value of the dollars one holds to become worth less over time. This effect can be substantial over long periods of time or at times of hyperinflation. For example, since the US left the gold standard during the 1930's, the value of a dollar has decreased to about 10% of its former value. If one had buried the 2010 equivalent of $200,000 in the backyard in 1920 it would be worth the equivalent of $20,000 today. This means what would once allowed one to buy a house would now allow one to buy only a mid-priced car.
Many individuals who feel they are investing very cautiously – for example keeping all of one's 401k assets in money market funds, - are actually taking great risk. Placing money in such assets for long periods of time almost assuredly results in not having enough money to last through retirement. The best way to guard against inflation is to hold assets that return more than inflation when it will be a long period of time before the money will be spent (for example, ten years or more). This means holding things such as stocks, bonds, and real estate. Some exposure to foreign securities can be even more effective since relative decreases in the value of the dollar will result in increases in foreign securities in dollar terms.
Note that traditional inflation hedges such as gold are generally poor investments since their value will not increase over time and there is a cost to their storage. Such assets are also subject to bubbles, as there appears to be at the current time in gold. If one wanted to hide money in the woods for great, great, grandchildren to find, gold would be a suitable choice. Otherwise, one should stick to other assets.
Depreciation in the value of assets tends to occur during deflationary times such as the 1930's and the 2007-2009 period. At these times the price of stocks and bonds tends to fall. As we have seen, real estate prices can also fall. The best way to guard against asset depreciation is diversification. One should have a mixture of different assets types (for example, US stocks, foreign stocks, bonds, and real estate or Real Estate Investment Trusts).
Within stock portfolios, mixtures of stock types will also help reduce the effects of decreases in certain sectors. For example, holding stocks in large and small companies, and holding both young growth stocks and the stocks of older, more established companies that pay a large percentage of their earnings out in dividends. In general, holding mutual funds in three or more asset categories will meet the requirement for diversification. For example, holding a large cap, mid cap, and small cap fund, or holding an aggressive growth, growth, and growth and income fund.
The other effective hedge against asset depreciation is time. Because stocks and other assets tend to have an upward long-term growth trend, the chance of earning money increase when they are held for long periods of time. For example, while stocks declined by about 40% in 2008 (with many individual stocks declining a lot more), in the period from 2009 to 2011 stocks have actually regained their former levels and increased somewhat.
A good strategy is to begin to pull money out of assets such as stocks and bonds when one will need the money within the next 5-10 years. This will substantially reduce the risk of a sudden market event affecting one's plans. As recent history suggests, even with severe market downturns, having the money set aside to pay for needed expenses while leaving other investments untouched can make all the difference.
