Investment is an art & Science: Sometips: 5 portfolio risk management strategies
Any investment, no matter how stable, involves a certain amount of risk, and smart investment aims for minimising these risks while maximizing returns.
Investments are mostly fraught with risks The degree only varies. Even the Bank deposits were at some point of time proved to be risky. Any investment, no matter how stable, involves a certain amount of risk, and smart investment aims for minimising these risks while maximising returns. One of the most effective means of achieving this objective is through portfolio risk management, which involves the identification, assessment, measurement, and mitigation of risk associated with any investment.
It starts from the first investment and continues throughout the lifespan of the portfolio. Risk management allows us to take a holistic approach, where we develop a long-term view of the portfolio, balancing the risks and rewards of different investments to ensure the healthy and stable growth of our capital.
Here are five key portfolio risk management strategies that every investor should follow:
Diversification of risk
The first step in building any portfolio is diversification. It is an investment strategy where we divide the investing capital between different asset classes such as stocks, bonds, commodities, treasury bills, cash deposits, or real estate. The diversification must extend within an asset class as well. For instance, one should buy stocks and bonds from different industries instead of parking all their money in one industry. Different assets react in different ways to a particular event. Diversification limits the investor’s exposure to any one asset or industry, allowing the portfolio to absorb the impact of an adverse event.
Allocate assets according to risk appetite
Asset allocation is the percentage of each asset in a portfolio. The key factor in determining asset allocation is risk appetite, which is the amount of risk one can take. Risk appetite can depend on an investor’s lifestyle and age. For instance, individuals in their 20s can afford to take bigger risks, allowing their investment to pay out in the long term, than someone nearing retirement age. At the same time, lifestyle factors, such as high expenses, can also reduce one’s appetite for risk.
People with a high-risk appetite can invest in fast-moving but risky assets, such as equities. Those with lower risk appetites should focus on low-risk investments like government bonds or treasury bills. It is also important to remember that since risk appetite is influenced by age and lifestyle, it will change over time. Hence, asset allocation must be adjusted according to the investor’s changing lifestyle or advancing age, particularly when close to retirement.
Be aware of the time horizon
Time horizon is the amount of time an investor should hold an investment. It is often dictated by investment goals, such as retirement or buying property. So, one may hold a stock or bond till they achieve their investment objective. Time horizon is usually categorised as short-term (less than 5 years), mid-term (5-10 years), or long-term (more than 10 years). It can also determine the amount of risk one can afford to take for a particular asset. A longer time horizon allows us time to let the investment grow. For instance, a mid-term to long-term time horizon is ideal when investing in equity markets. For the short-term time horizon, bonds are a safer bet. Ideally, a portfolio should contain a mix of short-term, mid-term and long-term securities to allow for cash inflow at regular intervals. This can be critical in emergencies and to ensure flexibility in investment decisions.
Lean towards liquidity
While we lock up most of our money in investments, it is always advisable to ensure that some of it can be easily liquidated through assets like money market securities. These instruments are some of the most stable and can be easily liquidated when required. Quick monetisation helps us to access our money in case of an emergency, and can allow us more flexibility in planning our investments. For instance, one can use the quick cash to bag a bargain when a selloff occurs. The ability to quickly liquidate also lowers the risk of exposure in case of crisis.
Avoid emotional decisions
One of the biggest mistakes in building a portfolio is in taking decisions based on emotions. It is easy to be influenced by rumours and be too emotionally invested in one’s portfolio. However, portfolio risk management dictates that we use risk analysis when evaluating any asset. Similarly, avoid getting attached to stocks by using stop-loss orders to limit loss or gain. A stop-loss order is placed when the broker is instructed to buy or sell a stock when it reaches a certain price point.
Portfolio risk management is critical to ensuring that investments show long-term growth and stay in tune with changing requirements. The careful consideration of risk at every step not only minimises our exposure to volatile markets but also helps us to stay agile in a crisis. It enables us to maintain a portfolio that has the flexibility to change with market fluctuations, hence, maximising our returns in the long term.
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