Today, we’re going to talk about how to manage risk as an investor. But to do so, I want to recall a bit of financial education I shared with you not too long ago. Recently, I addressed a very common question we get from clients and investors—what is an example of a high-risk investment?
🎬 WATCH: How to Manage Your Investment Risk
Put simply, high risk investment is one in which you, the investor, does not manage your risk. Of course, this begs the obvious question, how do you manage risk?
It doesn’t matter who you are—an aggressive investor aiming to make smart moves as you set yourself up for future success, a newcomer celebrating the beginning of your investment journey, or someone transitioning into retirement with a lifetime of aggressive investment strategies under your belt. Understanding risk management is absolutely essential.
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And we’re going to work together to make that understanding easier for you today. In this article, you’ll learn the multifaceted approach we recommend for managing your investment risk. This includes three core strategies (diversification, using stop-loss orders, and hedging) that each play a critical role in a comprehensive risk management plan.
My hope is that, by the end of this, you’ll be able to navigate through uncertainties in the market, as an investor, with greater confidence and stability, so you can meet your long-term financial planning goals.
In academic terms, risk is traditionally viewed as the probability of you losing money from your investments. However, here we define risk differently. We view risk as the probability of you not reaching your financial goals. Why? As we talk about quite a bit here, money is a tool, not the ultimate goal.
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So rather than focusing only on the monetary loss, we believe it’s more effective to focus on the greater implications of whether or not you can achieve the financial goals you’ve set for you and your loved ones. This can largely be managed through financial planning and discipline, as much as a solid investment framework.
Now, when it comes to managing risk, it’s important to remember what it is that you can control, as well as what you can’t. You can’t predict the future. You can’t control the stock market. But you can control your financial planning. And you can control the discipline you embody with your finances.
Diversification is the most common and foundational strategy. It involves owning broad asset classes—owning stocks, bonds, currencies, commodities, and within those, diversifying further into sub-asset classes. Diversification’s importance cannot be overstated as it matters greatly—your asset allocation, according to many studies, accounts for 85 to 90% of your portfolio’s return.
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Stop-loss orders are exactly what they sound like—they are automatic sell orders on your security set at a specific price or percentage loss. This proactive measure ensures that you're not exposed to drastic downturns without a predetermined exit strategy.
This involves trading one security to protect another security, such as owning a stock but also taking positions that will offset potential losses in the short term. For example, if concerned about the immediate risks to Apple stock, you might want to short-sell S&P 500 futures as a hedge, balancing short-term risks with long-term investment in the stock.
When you think about managing your own investment risk, I want us to remember what Warren Buffet said: “The number one rule to investing is don’t lose money. And the number two rule to investing is don’t forget rule number one.”
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The worst mistakes I've seen in my career are when investors stop managing their risk because they allow their emotions to dictate their decision-making—whether fueled by fear of loss or fear of missing out. By staying disciplined, embracing strategic planning, and continuously managing risks, you ensure the resilience and growth of your investment portfolio.