Reduce Your Investment Risk

One of the best ways to reduce investment risk is to have a diversified portfolio. Diversification entails spreading money among a number of different types of investments or asset classes, such as stocks, bonds and cash. Among these investments, investors can diversify even further, into large and small or domestic and international companies.

Portfolios should be based on the investor's tolerance for risk and expectations for performance. The portfolio likely will include stocks, bonds, mutual funds and cash.

Diversification prevents one poor investment from ruining the entire portfolio. One of the most effective ways to diversify is to invest in mutual funds, especially if an investor does not have enough money to buy a lot of individual stocks.

Because the markets for stocks, bonds, and cash do not all move in the same direction or to the same degree, an investor's portfolio that combines these asset classes should be less risky than one that includes only one type of investment. A diversified portfolio historically produces better returns than one that is concentrated in more conservative asset classes, such as short-term bonds or cash equivalents.

Although a diversified portfolio won't completely eliminate risk, it's protection during market corrections or crashes.

Asset allocation is another way to reduce risk. Most of a portfolio's return is determined by how investors allocate assets among different types of investments. Asset allocation is important because it determines how risky an overall portfolio is. If all of a portfolio's assets are concentrated in one area, such as stocks, it is likely to be more risky than a portfolio whose assets are spread out among diverse investment categories.

An asset allocation appropriate to an investor's goals and time horizon provides the best chance that an investor will meet his or her financial goals. In addition, an investor should examine his or her overall financial resources and personal ability to tolerate risk when making asset allocation decisions.

Investors should base asset allocation on two factors: the amount of risk they are willing to take and their time horizon. A portion of the money should also be invested in stocks.

All investment goals have a time horizon, which is the length of time between now and when the money being invested will be spent. For example, if you are saving to buy a new car next year, your time horizon would be a short one. If you are saving for a down payment on a house, your time horizon might be medium-term, say four years. If you are currently 45 years old and saving for retirement, you have a long-term time horizon of about 20 years. Over time, of course, long-term goals such as retirement or funding your child's college education will become medium- and short-term goals. As your time horizon shifts, your asset allocation should shift accordingly.

An investor with a short time horizon might want to avoid higher risk investments such as stocks or stock funds, because the growth potential offered by these investments over time can be offset by short-term volatility. In this case, it would be better to concentrate on more stable investments such as bond funds, or even money market accounts.