History has witnessed that the returns are much higher over a longer time horizon. The investor could take a hasty decision when the market crashes or the volatility increases, which could lead them to potential losses too.
An investment is a combination of two words, i.e. Risk and Reward. There is an old and a golden thumb rule in finance, stating Higher Reward, higher risk. The returns are directly proportionate to the amount of risks taken by the investor.
Risk is not always a bad thing, but risk management is a valuable tool to minimize the overall risk of the portfolio.
There are various strategies enlisted hereunder to reduce the investment risk of the portfolio.
Diversification is a portfolio risk management strategy to reduce the overall risk of the investments which combines a variety of investments within a portfolio Diversification could be across asset classes (Asset diversification), across sectors (Sectoral diversification) and across geographies (geographical diversification). Buying units of a mutual fund offers an inexpensive way for retail investors to diversify investments.
Also refer: Power of Diversification
2. Research and knowledge
Warren Buffet had once said that risk comes from not knowing what you’re doing. An investor must do thorough research and should have adequate knowledge about the business before investing in any company. The investors should analyze various parameters of growth, profitability, past performance, corporate governance, valuations etc. as well as compare it with its competitors in the same industry before deciding to invest.
3. Regular review
A good business may not necessarily continue to stay profitable over the long term. The golden but fictional stock market mantra – Buy & Hold for the long term may not always be suitable. Therefore, it is very vital for the investor to regularly review the investments, closely watch the business performance and finally understand the market dynamics of the industry.
Also refer: Buy & Hold, simple buy not easy
4. Rupee Cost averaging
One of the essential qualities to become successful is discipline. Disciplined regular investments provide the rupee cost averaging benefit. Rupee-cost averaging is a strategy to reduce the impact of volatility by spreading out your stock, and thereby, acts as a tool to reduce the overall risk of the portfolio as well.
5. Patience and Discipline
These two attributes to 90 percent of the success in long term investing strategy. Patience will avoid most of the hasty decisions without understanding the overall impact of the change in business dynamics. Patience will assist the investor in making a more informed decision considering the long-term timeframe.
6. Risk tolerance
Risk tolerance should be defined well in advance before making an investment decision. Affordability, ability and willingness to take risks form the overall risk profile of the investor.
7. Always have an exit plan.
Targets and stop loss for a specific investment should be well defined for the investor depending on the holding period. Stop-loss in the lowest price below which the investor won’t be willing to take any further loss, i.e. he is stopping the loss at that price. Setting up a stop-loss is very important and useful as it creates a rather automatic exit route for the investor devoid of his emotional attachment and loss aversion psychological behavior.
8. Invest in risk-free government bonds
If none of the above strategies works for you, the risk profile is most likely to be risk-averse. Therefore, it would be ideal for the investor to invest in risk-free government-backed securities to avoid any capital erosion. The returns are comparatively lesser in such securities.
Some of the low-risk investment products (as alternatives to direct equity) are as follows (in order of increasing risk):
- Government bonds: Government bonds are those financial instruments that are backed by the government and have a sovereign guarantee which makes it almost risk-free.
- Public Property Fund (PPF) PPF is a long-term investment instrument with a maturity of 15 years. Since PPF has a 15-year long tenure, the benefits of compounding increases as every year passes. The principal amount and interest are backed by a sovereign guarantee making it a low-risk investment as well.
- Bank Fixed Deposit (FD): A bank fixed deposit (FD) is a financial instrument offered by banks providing a fixed rate of interest, which is higher than the investments mentioned above avenues. The interest gets credited to the customer accounts depending on the terms of the agreement.
- Gold: Gold is considered to be a safe haven in India. More than its independent nature of risk as an asset class, it is an alternative investment to diversify their existing portfolio to reduce the overall portfolio risk. Investors can buy gold in physical as well as via mutual fund, sovereign gold bonds, and ETF listed in the stock exchange.
- Mutual Fund: A mutual fund is an investment fund that pools money from multiple investors to purchase securities based on the scheme mandate. An investor may choose the fund based on his risk appetite. It provides benefits like diversification to further reduce the variability of returns. Lastly, Mutual funds are managed by a team of professionals backed by the robust research team as well.
There are many strategies to reduce the risk of the portfolio. The investor may use one or a combination of strategies to protect the portfolio against the unexpected downside. The stock market may be perceived as a gamble. However, smart investors have taken advantage of such volatility by deploying the above risk management tools. Careful use of risk management would ensure maximum profit and minimizes the loss.