We all want to be wealthy, but just earning a substantial monthly salary is not enough to secure your financial future. This is where investments come into the picture. Well-managed investments can grow your wealth over time and help secure your financial future. But all investments carry risks, and a key goal of your investment portfolio should be to minimize overall risk while simultaneously maximizing your investment returns.
In this article
- Know Your Risk Tolerance
- Ensure Sufficient Liquidity
- Implement Asset Allocation Strategy
- Diversify Your Investments
- Monitor Portfolio Performance
- Focus on Time in Market
Luckily while it might not be possible to eliminate the risk of your investment portfolio, there are various ways you can reduce it. In this blog, we will discuss 6 key actions that you can take to reduce the overall risk in your investment portfolio, starting with understanding your risk tolerance.
1. Know Your Risk Tolerance
Risk Tolerance is defined as an investor’s ability to endure the risk of losing the capital invested. Typically risk tolerance depends on the age of the investor and his/her current financial obligations. For example, investors in their mid-20s who are unmarried have fewer financial responsibilities than investors in their late 50s who are married with college-going children. Thus, as a general rule, younger investors tend to be more risk-tolerant than older investors.
So if you start investing early in life, you can start your investment journey with a pure equity portfolio that is solely focused on aggressively growing your wealth. This strategy is, of course, not recommended if you are nearing retirement and need to focus on the preservation of wealth. By knowing your risk tolerance, you can figure out investments that deliver the best risk-return value to manage your overall portfolio risk.
2. Ensure Sufficient Liquidity in Your Portfolio
A key risk to your investment portfolio is that due to a financial emergency you might need to redeem investments when markets are down. This risk can be significantly reduced by maintaining adequate liquidity. Incorporating sufficient liquid assets into your portfolio will allow your existing investments to deliver optimal long-term returns and also will enable you to benefit from periodic market corrections.
One way to maintain sufficient liquidity in your portfolio is to set aside an Emergency Fund equal to 9 to 12 months’ expenses. In order to ensure easy accessibility, consider spreading the funds equally across your bank Savings Account and potentially low-risk investment options such as Liquid Funds and Overnight Funds. Once you have determined your risk tolerance and put some money aside to ensure adequate liquidity in your portfolio, it is time to figure out an asset allocation strategy that works for you.
Also Read: What is an Emergency Fund, Why Do You Need It, and How to Build it?
3. Implement an Asset Allocation Strategy and Stick to It
In simplest terms, Asset Allocation involves investing in multiple asset classes in specific proportions to ensure that your overall investment portfolio features minimal risk and provides optimal returns. There are various strategies to determine the perfect mix of key asset classes such as Equity, Debt, Gold, Real Estate, etc.
Ideally, you should consider investing in a combination of asset classes inversely correlated to each other, i.e., when one asset class outperforms the other asset class underperforms. One such pairing is Equity and Gold. If you look at the performance of these asset classes over the past 20 years, you can see that historically, when Gold has outperformed, Equities have underperformed and vice versa, as shown below:
| Performance of NIFTY 50 vs. Gold (2000 to 2020) | ||
| Period | NIFTY 50 | Gold |
| 2000 – 2002 | -12.3% | 5.6% |
| 2003 – 2007 | 43.1% | 16.7% |
| 2008 – 2012 | -0.9% | 23.5% |
| 2013 – 2016 | 8.2% | -2.0% |
| 2017 – 2019 | 9.2% | 4.2% |
| 2020 | 13.8% | 47.6% |
At present, there is no single asset allocation strategy that you can stick to through your entire investment life. Factors such as the age of the investor, risk tolerance level, investment horizon, etc., can play a key role in determining which asset classes to invest in and what proportions so that your portfolio returns are maximized, and the overall risk is minimized.
Know More: What is Asset Allocation and How to do it Right?
After you have determined which asset allocation strategy works for you, you need to work on further reducing portfolio risk by diversifying your investments within the same asset class.
4. Diversify Your Investments
Once you have determined which asset classes suit your investment objectives, you can reduce overall portfolio risk further by diversifying your investments within the same asset class. The basic idea behind diversification is to spread your risk across multiple types of investments within the same asset class so that all your proverbial eggs are not in the same basket.
For example, you can diversify your Equity Mutual Fund investments by spreading your investment across multiple Mutual Fund categories such as Large-Cap Funds, Large and Mid Cap Funds, Multi-Cap Funds, Flexi-Cap Funds, etc.
5. Periodically Monitor Your Portfolio’s Performance
As an investor, you should look at staying invested for the long term but at the same time, but that doesn’t mean you invest and forget. You need to keep an eye on the performance of your portfolio and do periodic reviews.
However, you need to make sure you are not doing these reviews too often. The ideal time frame is to review your portfolio once every year. If you can’t wait that long, then once in six months is the frequency you should adopt. Anything less, and you are likely to make frequent changes, and it can work against you.
That’s because some asset classes like Equities are prone to short-term volatility, so you must make a conscious effort to overlook short-term volatility and only change your investments if the poor performance persists over an extended period. This where the need to ensure “time in the market” instead of trying to “time the market” comes in.
6. Focus on Time in Market (Instead of Timing the Market)
As an investor, your most powerful wealth-generating tools are time and the power of compounding. This means that you must focus on staying invested, i.e., maximizing your “time in the market,” instead of trying to make a quick buck by “timing the market.” By staying invested for the long term, any risk to your portfolio due to short-term volatility will be significantly reduced.
While it is a good idea to grab lucrative opportunities that present themselves, long-term wealth creation requires patience and disciplined investing. Consider having one or more Systematic Investment Plans (SIPs) in place to ensure that you get the benefit of disciplined investing while staying invested in the long term.
Bottom Line
As every investment you make comes with some risk, it is not possible to create an investment portfolio that optimizes returns, ensures Zero Risk, and at the same time achieves your financial objectives. That said, implementing the 6 tips mentioned above can definitely help you find the appropriate balance between risk and return so that your investments continue to grow over the long term and help you achieve your financial goals.
