I have heard people compare the stock market to a big casino where investors gamble their money away. For me, the stock market is more like quite like a one big poker game. Luck has no place, just good skillfully made decisions and bad decisions. Where the information you have is in the cards you hold. And the information available to all is in the cards that have been dealt face-up on the table and finally, the information that you trying to know but can never really know, is in the cards that the other players have.
In view of this, the question, then remains – How can I make the best decision possible given what I know, what I don’t know and what I can guess?
Investment Risk: “Buy, Hold, and Pray…”?
While investing, do not play the game of luck – essentially buying, holding and praying that things work out. Luck is a short-term friend that can quickly turn to a foe. Rather employ skill in your decision making. Skill will help you prevail in the long run provided you survive the ups and downs of the market. At the end of the day, you can only guess the moves other investors will make or the information they have.
Therefore, when looking at investment risk management as it applies to financial planning, we are referring to the possibility of loss relative to expected return on investment. Thus, the growth of your individual wealth is determined by mathematical expectancy. This can be simply understood as expectancy is equal to the probability times the payoff.
i.e.
Expectancy = probability x payoff
Whereby, the payoff is half of the expectancy equation and is determined by the quality of your risk management. This simply means that the likelihood of growing your wealth increases with its probability.
Strategies to Reduce Investment Risk
While trying to reduce investment risk, you need to convert the uncertainty of investing in an unknowable future into a confident outcome by increasing the probability of payoff.
This can be down by:
Strategy 1: Educating Yourself to Better Estimate Expectancy
Becoming a skilled investor should be your number 1 goal. Getting smarter about investing is one of the simplest and cheapest ways to reduce your investment risk. Knowledge is power and with it comes better decision making and probabilist thinking. You’ll be better equipped to make better decisions with the incomplete information you’ll have on hand.
When you take a few minutes to estimate the potential risk of your investment based on historical performance, you are more empowered to make a better investment decision.
How much loss can you take?
This is managing expectancy. The strategies presented here, all work towards increasing the probability of payoff (reducing risk), therefore increasing expectancy. The better you are able to manage these things, the better you’ll be at building wealth using traditional asset classes.
Therefore, the more you know, the easier it will be to build wealth while lowering risk and increasing expected payoff. From my experience, the greatest investment risk comes from not fully knowing it exists. Thus learning reduces the risk of investing.
Learn More: No Shortcuts. No Cheat Sheet. Expectancy Investing!
Strategy 2: Balancing Risk & Return with Asset Allocation
You cannot completely avoid risk if you want some growth in your portfolio. Therefore, plan the life of your portfolio weights as you gradually transition into retirement using the appropriate asset allocation. Asset allocation can provide the optimal distribution method for each stage that incorporates inflation, tax and market risk factors.
For instance, if your goal right now is to pursue growth, and you are willing to take on risk to reach this goal, you may decide to place more of your assets in stocks. Having portfolio weights of 80% stocks, 15% bonds and 5% cash. And as you move towards retirement, shift your weights to reduce stocks and increase on bonds and cash to lower portfolio risk. The timeframe here is a critical factor to balance the risk and rewards of each asset class.
| Risk vs. Reward | Market Risk | Potential Return | Other Risk Factors |
| Stocks | High short-term market risk | Higher long-term returns | Outpaces inflation better over the long run. |
| Bonds | Lower market risk | Lower long-term returns | High inflation risk over time. Bond prices likely to fall when interest rates rise. |
| Money Market Instruments | Low market risk | Stable | Low potential margin to outpace inflation. Not insured by deposit insurance corporation or government agency. |
Note: Past performance doesn’t guarantee future results of a payoff.
Learn More: 3 Paths Of Wealth Accumulation
Strategy 3: Portfolio Diversification
Within your asset classes, ensure your portfolio is diversified. This means that you’ll need to select a variety of individual investments within each asset class to reduce investment risk. It will help lessen the impact of market volatility on your portfolio.
Therefore, seek to buy stocks at least 10 stocks in several different industries to reduce the possibility of loss. If the return of one stock falls, the return on another may be rising, which then offsets the poor performing stock.
Note: this doesn’t eliminate risk, rather increases the probability against investment loss.
Learn More: 9 Biggest Investor Mistakes & How to Avoid Them Like A Ninga
Strategy 4: Dollar-Cost Averaging
Cost averaging is an investment strategy that seeks to smooth out the effects of market fluctuations in your portfolio.
In this approach, you apply a fixed amount towards the purchase of stocks, bonds or mutual funds at regular intervals. As a result, you purchase shares when prices are low and fewer shares when prices are high. Over time, your average cost per share will usually be lower than the average price of those shares.
This strategy can result in better average share price than trying to time your purchases. See the illustration below:
| Monthly Intervals | Share Price | Investment | Shares Purchased |
| January | 51.50 | 10,000 | 194.17 |
| February | 50.30 | 10,000 | 198.81 |
| March | 53.45 | 10,000 | 187.09 |
| April | 45.20 | 10,000 | 221.24 |
| May | 38.95 | 10,000 | 256.74 |
| June | 42.65 | 10,000 | 234.46 |
| TOTAL | 47* | 60,000 | 1,292.51 |
* Ksh 47 is the average price per share. Ksh 46.42 is the average cost per share using dollar-cost averaging.
Learn More: What is a Mutual Fund and How to Invest in them?
Strategy 5: Buying Undervalued Assets
We naturally seek the prices for everything we purchase, so why not do the same for the investments we make. The price you pay on an asset determines how much you can potentially make once you decide to sell it. Wealth is created where you buy an asset well below the market value, and sell it later at its market price.
Undervalued assets tend to have lower investment risk, as you naturally capitalizing buying bargains to reduce risk and enhance wealth. This strategy is great for both stocks and real estate.
Learn More: How to Evaluate The Quality of a Stock for Long-Term Value Investing
Key Takeaways
- Be cautious and make the best investment decisions based on concerns about gains and losses. With every loss or gain, you will learn the pitfalls of your own decision making. You will learn to rise above the noise and embrace uncertainty rather than fear it.
- Frequently review your asset allocation and diversification strategy to ensure that your risk level matches your reward with your long-term investment goals.
- Adopt dollar-cost averaging to smooth out the effects of market volatility over time and since its systematic, it will help remove the emotions from your financial decisions. Life can get quite random: the stock market crash of 2008 and the COVID-19 pandemic of 2020. It doesn’t help to think too much about it or dwell in it.
- Think like a victor: I made the best decision given the information I had at the time. The outcome may not be ideal but made the best decision given the information on hand. Plant seeds of resilience and be able to overcome and maintain a ready mindset.
Focus on your decision making process, not luck.
Happy Investing!
Image credits: Top by Clifford Photos from Pexels
Disclaimer: This information is provided to you as a resource for informational purposes only.