In life, risk stems from uncertainty. Since nobody really knows what is going to happen in the next moment, let alone tomorrow, risk becomes our constant companion. The same logic follows in the investment world as well. Almost all investment products are subject to uncertainty in terms of returns. Hence, all investments carry a certain level of risk. Now, just as you don’t stop going about your daily lives because of risk, you must also not stop investing because of risk. Instead, you should choose to take steps that can mitigate the overall impact of risk on your investment portfolio.
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Five steps for reducing portfolio risk
Know your risk profile – the first step is to determine your risk profile. This will help you understand your capability, willingness and need to take risk. The investment portfolio that you create should ideally reflect your risk profile. For example: if you are a high risk taker then you can invest in high risk instruments like equities. However, if you are a low risk taker then your portfolio should be skewed towards fixed income instruments.
Split and strike a balance: invest in a mix of assets – the key to mitigating portfolio risk is creating a diversified portfolio. This can be achieved by investing in a mix of uncorrelated or mildly correlated asset classes. This would ensure that in case of an adverse event or development only a certain portion of the portfolio gets impacted.
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Divide to thrive: achieve within asset class diversification – it is important to remember that simply diversifying the portfolio across asset classes will not achieve optimal diversification. For this, one needs to do within asset class diversification as well. Even within an asset class there are various categories of investments that carry varying levels of risk. This should be taken into consideration while building a diversified portfolio. For example: within the asset class equities, small-caps generally carry a higher level of risk when compared to mid-caps.
Invest through a systematic investment plan (SIP) – an SIP is an investment vehicle that can help investors gain exposure to a select asset class through the investment of a small or large amount of money, at regular intervals and in a disciplined manner. SIPs can help mitigate portfolio volatility as the investor regularly invests a fixed amount of money at regular intervals, at multiple price levels. Hence, the purchase price of the security gets averaged out over a period of time. Additionally, investment through an SIP can help investors reap the benefits of compounding which can potentially enhance long-term portfolio returns.
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