Investing always carries some level of risk, but there are steps you can take to manage that risk and increase your chances of success. Ways to manage risk include diversification, setting clear financial goals, and doing your research.
Investing offers a great way to potentially increase your wealth, but it can also lead to major losses if not done properly. Risk is a part of investing — without it, you wouldn’t be able to potentially grow your money as quickly.
Though it’s impossible to completely avoid taking on some risk in the stock market, there are ways to minimize your risk while maximizing your potential for returns.
Whether you’re an experienced or first-time investor, understanding how to manage risk is essential in order to secure good returns on investments.
In this post, we’ll explain the relationship between risk and return and offer strategies to assess risk and make smarter investing decisions.
Understanding investment risk
Risk is the possibility of losing money due to fluctuations in the market.
Investing always comes with some degree of uncertainty, and knowing how to measure and manage risk is key to achieving your investing goals.
All investments — stocks, bonds, mutual funds, and ETFs — have potential to lose their value if market conditions worsen. Even conservative investments like bonds come with risk.
Keep in mind that not all risk is bad. In fact, there’s typically a trade-off between risk and reward.
The relationship between risk and reward
The riskier the investment, the higher the potential return, but the more likely you are to lose money. On the other hand, the less risky the investment, the lower the potential return, but the greater likelihood of preserving your capital.
Determining risk and reward is a delicate balance that requires careful consideration before making any investment decisions.
But one thing is for sure: No investment is entirely risk-free. Even putting your money in a savings account carries a degree of risk, albeit a minimal one.
There are various types of investment risks, including market risk, interest rate risk, and credit risk. Let’s break down the differences between each one.
Common types of investing risk
Before you dive in, it’s important to Understand the different types of investment risks and how they can potentially impact your investments.
Types of risk can be divided into two categories: Risks that affect the overall market, or systematic risk, and risks that affect a specific industry or sole investment, or unsystematic risk.
Systematic risks include:
- Market risk: The possibility of losing money due to unpredictable fluctuations in share prices due to economic, political, or social factors
- Interest rate risk: The chance an investment will lose value driven by changing interest rates
- Inflation risk: The possibility that rising prices could outpace the return on your investment
Unsystematic risks include:
- Financial risk: The chance that the company or issuer defaults on their obligations
- Business risk: The possibility a company will lower its profits or fail
Understanding and managing these risks is key to successful investing. While some risks can’t be avoided, there are some types of risk you can successfully reduce through diversification.
Balancing your portfolio through diversification
As the saying goes, “don’t put all your eggs in one basket.” Diversification is a fundamental principle to mitigate risk and build a stronger investment portfolio.
Diversification involves spreading your investments across multiple industries and asset classes, so you lower the chance of suffering significant losses if one investment performs poorly.
Putting time on your side
Another way to reduce your risk is by taking a long-term approach. As time goes by, the impact of market volatility is lessened, meaning there is generally a lower chance of losing money.
This is due in part to the nature of the market itself: While there may be short-term fluctuations, over the long-term, the market tends to move upward. Case in point: since 1928, the US stock market has risen an average 9.8% per year.
Tip: The longer you stay invested, the more time you have to ride out any short-term fluctuations in the market and benefit from long-term gains.
How to determine your risk tolerance
Risk tolerance is your ability to withstand and handle risk in your investment choices. Everyone has a different level of comfort when it comes to taking risks, and this will ultimately impact the types of investments you choose and how you build your portfolio.
Understanding your risk tolerance takes careful consideration of your financial situation, personal preferences, and overall comfort level.
Asking yourself questions including how much you can afford to lose, how long you plan to invest, and what your overall investment goals are will help you build a well-diversified portfolio that balances risk and reward.
Knowing your risk tolerance will also help you avoid making impulsive decisions based on emotion. By taking the time to really understand your risk tolerance, you can build a portfolio that aligns with your goals and helps you achieve them in a way that feels comfortable and not overwhelming.
Revist and adjust your portfolio
Achieving a well-diversified portfolio is crucial for long-term success. But simply allocating your assets once and letting them ride may not be enough to ensure that your investments remain diversified over time.
Market fluctuations and changes to your financial goals can gradually shift the balance of your portfolio, leaving you overexposed to certain sectors or asset classes. That’s why it’s important to regularly reassess your portfolio and make adjustments as needed.
By doing so, you can ensure that your investments remain appropriately diversified and aligned with your financial objectives.
What’s more, keeping a watchful eye on the market can help you make more informed decisions about your portfolio — and manage any risk when the market gets volatile.
By monitoring market trends, you’ll be able to pinpoint whether a particular industry or company is experiencing growth or decline, and adjust your investments accordingly.
Stick to your plan
Investing can be a thrilling ride. But if you’re not careful, fear of missing out or a desperate desire for quick returns can drive you to make hasty decisions and take on unnecessary risks.
That’s why you should create a solid investing plan and stick to it. Playing the long game with a diversified portfolio of quality investments is the smartest method to achieve the returns you want.
You should also never invest more than you can afford to lose. This means setting a budget for yourself and sticking to it, even when the temptation to take risks is high. This way, you can reduce the risk of losing money that you can’t afford to part with.
Conclusion
Remember, investing is a long-term game, and it’s important to prioritize your financial stability over short-term gains.
One way to align your portfolio with your risk tolerance is through eToro’s virtual portfolio. Get started with investing here.
This communication is for information and education purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments.
This material has been prepared without taking into account any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication.