2 Ways to Reduce Your Investment Risk

 Introduction

Do you want to know how you can reduce the investment risk of your investment portfolio? Then you should do the following two things: Diversify your investments and invest in "uncorrelated markets".

Reduce risk by diversifying

You have all, no doubt, heard the expression of not putting all of your eggs in one basket. That is just what the concept of diversification is all about. Instead of betting the barn on one stock or company, you invest in several companies. That way if one stock bellies up, you will have your money invested in other companies that are remaining afloat. One case in point: Not long ago, Enron was a so-called "hot stock". Because of that, many people invested most of their money in it. Not only that, some couples both invested their money and their labor in that company. That is to say that they worked for that company too. Thus, when the company went under, they experienced a double-whammy! Not only did they lose their investment, they also lost their jobs at Enron. That's why you want to diversify. That way if the company goes under, you might lose your job but still have your investment since you will have invested your money in other companies than the one that you are employed by. One thing more: You might have lost your job, but your spouse still has hers since she works for another company.

How do you go about diversifying your investment portfolio? You can do this by simply investing in a mutual fund, an index fund, or an ETF. A mutual fund is simply a basket of stocks (companies) that is actively managed by a fund manager. An index fund is similar to a mutual fund minus the hands-on manager. It is "passively managed". That is to say that it is set up to mirror an index such as the S & P, NASDAQ, or the Dow Jones Industrial Average and left to run on its own. Last, an ETF looks like a mutual fund that tracks an index but trades like a stock. By investing in any one of these three financial instruments you achieve instant diversification.

 Reduce risk by investing in uncorrelated markets

Another way that you can reduce your investment risk is to invest in "uncorrelated markets". That way if one market is in a decline, the other one may be experiencing growth. For example, the stock market might be in a slump, but the bond market might be on fire. Or, the US market might be experiencing a bear market, but the international markets might be experiencing a bull market. In other words, when one market is down, another market might be up. That's why it is important to invest in various "uncorrelated markets". Imagine investing in, say, a market that is experiencing a bear market not just for 1 year but for 5 to 10 years using the investment strategy of buy-and-hold, or, as someone once put it, buy-and-hope. Because the market is experiencing a slump, you fail to make any money. Instead of making money, you are losing it through commissions (i.e. portfolio turnover), taxes, and price drops. Now if you followed my advice and invested in a market that runs contrary to this market, that is to say, you invested in a market that is up while this market is down, you might lose in this market but win in the opposing market.

 Summary

These, then, are just two ways that you can reduce the risk to your investment portfolio: By diversifying and by investing in "uncorrelated markets".