Managing Investment Risk
Key Takeaways
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To manage risk, you should invest in a diversified portfolio of different investments
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You should allocate your capital to different asset classes according to your desired risk-return profile
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Dollar-cost averaging removes the risk of timing the market wrongly
Know Your Risk Appetite
Can you afford to lose all of your investment?
Every investment bears risk. In some cases, you could lose some or all of the money you invested. In other cases, you may have to bear market price fluctuations. Then, there are cases where you lose income or return on investment.
Your willingness to accept risk should take into account:
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Your current and future commitments. If you have immediate needs, you should invest in liquid and low-risk assets such as Singapore Savings Bonds.
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Your investment horizon. The longer your investment horizon, the more time you have to ride out market fluctuations and grow your investment.
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How much investment capital you can afford to lose. If your investment suffers a loss, consider how it will impact your commitments such as loan repayments and your future goals.
As all investments carry risk, you should consider the risk-return tradeoff before deciding on an investment. Generally, the higher the potential returns, the greater the risk.
Note: Your risk appetite is more about how much you can afford to lose rather than how much you want to make.
Risk-return Trade-off
The higher the potential returns, the higher the risks.
For example, if you were to invest in futures, you might expect high returns. However, at the same time, you need to be prepared for the high level of risk involved. The question to ask yourself is, “Can I afford to lose a significant amount, or even all of my money?”
Managing Risk
All investments involve some measure of risk. You can use these three investment strategies to help you manage risk:
Diversification
Diversification refers to spreading your investments over a variety of assets with the aim that a portfolio of lowly-correlated assets does not all move in the same direction at the same time or even if they do move in the same direction, it should at least be by different degrees.
You may give up some gains, but the overall risk of loss is reduced and you will be in a better position to withstand ups and downs in the market.
For example: If you invest in just a single company's shares, you may lose all your money if the company goes bankrupt.
However, by distributing your investments over five companies, you risk losing only 20% of your money if one company goes bankrupt.
You can diversify your portfolio by:
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Investing in different asset classes (e.g. shares and bonds)
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Within each asset class, invest in different securities, industries or countries (e.g. a portfolio of different shares or exchange-traded fund that tracks an index)
Correlation
Assets that move together in the same direction are said to be correlated. One way to diversify is to combine assets which move randomly or in opposite ways. These assets can be described as being negatively correlated, or even not correlated at all.
Investing in assets that are not correlated is beneficial because they are not impacted by the same market trends. Hence, shocks in one market will not affect the others.
For example: If the construction industry suffers a downturn, both the share price of a construction company and the price of steel, which is used in construction, will drop. These two are positively correlated.
However, industries dealing in healthcare will not be affected and hence the share price of a healthcare company will move independently or randomly – they are not correlated.
Asset Allocation
Deciding how to distribute your investments is part of the asset allocation strategy. Here are five factors to consider before you decide on your asset allocation:
Your investment objectives – Do you want to preserve your capital, grow it, get a regular income or have liquidity? For example, if capital preservation is your key goal, you should allocate more funds in your portfolio to conservative choices with less risk attached (E.g. Singapore Savings Bond).
Your investment horizon – Which life stage are you at, and what are you saving for? Each goal has its definite investment horizon. Generally, the younger you are, the longer your investment horizon.
Your risk profile – Knowing your risk tolerance allows you to invest comfortably without potentially losing more than you can afford to. If you have a low tolerance, you should allocate more funds to lower-risk assets, though you should also expect lower returns.
Asset mix – Knowing how various assets are correlated and what risks and returns to expect from each will help you decide on your preferred asset mix.
Current and expected market conditions – Have your personal circumstances changed? Even if your situation has not shifted, the markets are likely to have. It is important to monitor and re-balance your asset mix regularly in order to maintain a balanced portfolio.
Keep in mind that your investment objective, horizon and risk profile are likely to change as you go through different life stages. You will want to re-evaluate these from time to time.
Dollar-Cost Averaging
Market conditions are hard to predict. Trying to buy low and sell high can be challenging and most investors fail to sustain any significant returns this way.
A more disciplined approach is dollar-cost averaging. With this approach, you invest a fixed sum of money at regular intervals, whether the market is up or down.
For example, if you invest $1,000 every month, you buy more shares when the market is down and fewer shares when the market is up.
Over a long investment horizon, dollar-cost averaging gives you the best chance of paying a lower average price.
