How to manage investment risks
Investments of any kind are subject to various risks. Even those investments considered risk-free expose the investor to a loss of purchasing power due to inflation.
While an investor cannot completely do away with the risks, one can manage them in a manner to reduce the negative impact of those risks on one’s investment portfolio.
First and foremost, do thorough research about the investment and understand the risks. There is no substitute for that. If one is unable to do the research oneself, it would be prudent to seek professional help.
The second step would be to diversify across different investment options. The key word here is “different”. Diversification may be done across:
Even within an asset category, it is important to diversify.
A dual approach of high quality and diversification would generally safeguard one’s portfolio against most risks. However, there are certain risks that cannot be diversified away, e.g., market-wide price volatility. When the entire market goes down, the individual securities within the market will also see price depreciation.
The negative impact of such a risk may be avoided by matching the nature of the investment option with the investment horizon; e.g., it would be risky to invest in equity markets when the investment is for the short or medium term. At the same time, long-term portfolios must be protected from inflation. In such a case, a prudent approach would be to invest in securities that have the potential to beat inflation over the long term. At the same time, it would be wise to avoid highly volatile or even illiquid investments when the goal is near-term or short-term.