How can you reduce your level of risk?
Nobody wants to be subjected to an undue level of risk. The most effective ways to
reduce your degree of risk are to have an adequate amount of diversification,
build an intelligent asset allocation, and invest in the appropriate assets for your time horizon.
If you have your entire account in one stock and its value falls,
the value of your entire account will decline by exactly as much as the
stock fell. If you are equally diversified across two stocks and one
declines, you will only have a 50% exposure to that loss. With three stocks, your exposure goes down to 33.3%. And so on. This dramatic reduction in risk continues until you reach a point of between 20 and 30 stocks. The goal is to become diversified enough to enjoy the upside
benefits of good investing while minimizing your downside risk exposure.
There are also ways to make the most of a diversified account. You can invest in a range of securities that
have different levels of standard deviation (risk). You can choose stocks from different industries. But the most important thing you can do is to diversify across asset classes (invest in different types of assets). This is called asset allocation.
One of the strengths of smart asset allocation is that it allows you to invest in securities with a strong
low correlation. This means that one investment will zig while the other zags, so that you can
be pretty sure you'll always have some investment doing well. In the "Asset Allocation" chapter you'll learn how to choose investments with low correlation, and how these can add value to your total account.
The most important factor to consider when trying to calculate risk is your time horizon -- how long you can leave your investment without touching it. If you are investing for the long haul, you can most likely afford to include more risk in your portfolio. If you are making a short-term investment, however, you probably want to build a less risky portfolio. Either way, the key is to develop a portfolio whose degree of risk is
appropriate for your needs. Bear in mind two
critical rules about time horizon:
- Market risk is usually short-term.
- The longer your time horizon, the more risk you can most likely afford to take.