Managing risk is a key part of investing and strategies for achieving the right balance can vary greatly depending upon your specific resources and requirements. You should always expect there to be unpredictable variables involved in any financial decision you make. Risk management strategy essentially involves identifying and analyzing the degree of that unpredictability with a given investment and then determining whether you can accept that level of risk or how you can potentially mitigate it to acceptable levels.
A key means to better ensure the future profitability of your investment portfolio is through various methods of asset allocation. This is the process by which you divide your available capital across various types of investments. The underlying philosophy is that diversification is the best way to mitigate risk and optimize returns.
- 1 Identification and analysis of risk
- 2 Risk tolerance
- 3 Asset allocation strategies
Identification and analysis of risk
Before we delve into some strategies of asset allocation as a means of managing the risks involved in investing, it’s important to first understand how we determine the risk involved in any given investment. While it is not possible to come up with a concrete, exact figure, there are some means of measurement that will give you a fairly reliable estimate of the potential risk.
This measurement looks at past growth and returns in order to better gauge what we can expect to see in the future. By comparing the overall growth of various indices (such as the S&P 500) with the growth of the stock you are interested in over the same period of time, you can see how much it deviated from the general market. This will show you if it has done better or worse than the market as a whole and further, how much it more it fluctuated in the given time frame. The more widely a stock fluctuates in comparison to the general trend, the higher the risk involved in the investment.
This is the conditional value at risk. With this method, investors can assess how high the potential returns on an investment are in comparison to how high the risk of loss. In this way, you can see if the potential reward outweighs the potential cost. It is calculated by measuring the amount of potential losses, the probability that loss will occur, and the time frame in which it would happen. It then determines whether those losses exceed the value.
In addition to calculating the actual risk of the investment, it’s important to understand your own personal risk tolerance. This is not so much a quantifiable figure as a general assessment of how much risk you are willing and capable of taking on.
Factors to take into account include:
The younger you are, the more time you will have to bounce back from potential losses which mean you will be able to take on more risk than someone who is, say, just five years from retirement. Determine exactly how many years you have until you plan to retire to see how much time you have to grow your investments.
Everyone starts out with a different amount of capital available for investing. If you have a lot to begin with, you can afford to incur more losses along the way without going bankrupt. Those starting out with less will have to be more careful that they don’t suffer any major losses.
This factor includes both how much you hope to gain and how much you are willing to lose. If you hope to see substantial gains, you will have to accept higher risk. On the other hand, if your goal is to simply achieve steady growth, you should focus on mitigating risk as much as possible.
How much experience you have with investing will also factor into your potential risk. If you already know your way around the stock market, you will be better at identifying risk and determining the best investments. If you are new to the game, however, you will be at a higher risk for making unsafe or bad investments. In the latter case, it is a good idea to do your research beforehand or even hire a professional to manage your portfolio for you.
Asset allocation strategies
There are three main types of assets: equities, fixed income, and cash. Each of these come with differing levels of risks and returns and will behave differently over time. The general theory of asset allocation is to structure your portfolio according to your own personal risk tolerance and investment goals. By balancing the distribution of your finances among these three main categories, you can better ensure you achieve the goals you set out to achieve.
Strategic asset allocation
This method involves identifying a specific ideal balance at the outset and then periodically revisiting your portfolio to rebalance it. For example, a conservative allocation of assets might be 40% in equities, 40% in fixed income, and 20% in cash. As your investments mature over the years, however, this initial balance may shift so that one area has a significantly higher percentage of your total assets than the other. For this reason, it is important to regularly (either annually or once every two to three years) to reallocate your finances so that the initial balance is again achieved.
Tactical asset allocation
This is a strategy for those with a relatively higher risk tolerance. It attempts to capitalize on high short-term gains by temporarily allocating a higher percentage of your investments into sectors currently experiencing higher rates of growth. This is a very active strategy as it requires relatively frequent reallocation as well as constantly observing market trends to identify the best investments for quick, short-term gains.
Dynamic asset allocation
This is a more conservative approach which seeks to minimize risk as much as possible by moving your assets into those sectors with the least fluctuation and the most stable growth. It is also a somewhat active strategy in that you will, ideally, need to identify those investments that are fluctuating too much in the early stages so that you can reallocate your money before incurring significant losses.