Thanks to decades-long trends that have lowered costs for trading and increased access to the markets, it’s now easier than ever to become an investor.
Some of the latest innovations include commission-free online stock trading and the introduction of fractional shares, which allow investors to buy smaller, more affordable “slices” of otherwise prohibitively priced stocks.
While these developments are indeed wonderful, they don’t change a fundamental aspect of investing—namely, that investing is all about balancing the potential for making money with the possibility of losing it.
Whether you’re a new investor or an experienced one, have a little bit of money or a lot, managing risk is key to success. With that in mind, here are four risk-management principles to get you started—and to stick with throughout your investing career.
1. Align your risk with your goals
What are you investing for and how are you going to achieve it? To create a successful plan, you first need to identify what your goal is: a comfortable retirement, the down payment on a house, a trip you hope to take in the next few years?
Once you know your goals, ask yourself how quickly you want to achieve each and how much risk you’re willing to take—financially and psychologically—to get there. Could you afford to lose much of the money you’re investing? How would you react? If the answers are “no” and “poorly,” it doesn’t mean you shouldn’t invest; it just means you should invest in ways more in line with your risk tolerance and time horizon.
If you’re saving for something you’ll want or need soon—such as a down payment on a new house—you’ll probably want to invest in something relatively stable, like a money-market fund or U.S. Treasuries. If you’re saving for a retirement that’s still decades away, you may be comfortable with a larger portion of your savings in stocks—which have historically come with more risk but also delivered higher returns—since you’ll have much longer to potentially recover from a downturn.
Diversification means spreading out your investments—both across different asset classes (such as stocks and bonds) and within them (such as U.S. stocks and international stocks).
Each asset class plays a unique role in your portfolio. Stocks provide the potential for growth and could make up the majority of your portfolio when you’re young and have many decades to benefit from compound growth. Bonds, on the other hand, can help preserve your capital, which becomes all the more critical as you approach retirement. What’s more, asset classes don’t always move in tandem, so when one is doing poorly, another may be doing well. Holding a healthy mix of assets can help reduce the impact of any single investment on your portfolio’s performance.
That said, diversification still matters even if you’re investing solely in stocks. A portfolio of 20 equities in a variety of industries, for example, is generally far less risky than a portfolio of just two.
Achieving long-term investing success isn’t just a matter of creating a portfolio with the right mix of investments for your goals and time frame. As the markets rise and fall, the investments in your portfolio will grow and shrink in value—so much so that, over time, your portfolio could become either less or more aggressive than you’d intended. After a long bull run, equities could account for a much larger chunk of your overall portfolio than you’d planned—leaving you exposed to unwanted risk.
This is what makes rebalancing so important. By regularly selling positions that have become overweight in relation to the rest of your portfolio and moving the proceeds to positions that have become underweight, you can bring your portfolio back to its original target allocation. It’s a good idea to do this at least once a year, and more frequently if markets are making big moves.
Again, even if you invest only in a handful of individual stocks, don’t let any single name or type of stock represent too big a portion of your overall portfolio. Ask yourself what would happen financially and psychologically if your biggest position significantly declined or got wiped out altogether. If that scenario is troubling even to contemplate, then your position probably needs to be trimmed back.
4. Watch out for leverage
Leverage is a strategy that uses borrowed money to increase an investment’s potential return—often through products like leveraged exchange-traded funds, futures contracts, margin loans, or options. While such products can amplify returns, they can also disproportionately magnify risk, making it especially easy to get into financial trouble. Indeed, some of the saddest stories involve investors who suffered catastrophic losses because leverage worked against them.
Ultimately, if you don’t understand leverage, it’s best to steer clear of it altogether. Even relatively sophisticated investors should proceed with caution, lest their desire for outsize gains deliver outsize losses instead.
Investing is a lifelong endeavor replete with plenty of trial and error. You can learn as you go, and explore different approaches as your interests and goals change. The important thing is to diversify, rebalance regularly, and take a cautious approach to riskier practices in order to get where you’re going without undue turbulence.