Investment is a risky business. This is the reason why many find the world of investment quite daunting. According to Forbes, 65 percent of millennials and 6 percent of Gen Z find stock market investments scary.
But, if you play your cards correctly, you can minimize the risk and maximize the returns.
After all, not everyone can be a daring individual and invest in instruments that are highly risky, despite the fact that such instruments lead to the greatest returns possible. For instance, as mentioned by Financially Simple, the best three-year period for stock owners was during the Great Depression. The subsequent best returns were experienced during the 2009 recession.
Rather than taking such decisions and risking it all, for the most part, it is better to minimize downside risk by diversifying your investments. Here is how you can do so.
- Create a Probable Maximum Loss Plan
You can never be sure that any of your plans succeed unless you analyze all the risks involved and then proceed accordingly. This is true for portfolio investments, as well.
Before you begin investing your money in different instruments, it is essential to know how much money you can end up losing by your decision. This is where a Probable Maximum Loss Plan comes in.
This plan helps in avoiding the loss of a significant chunk of your portfolio. By calculating the maximum amount you can lose in each instrument, you can then align your investment decisions with your long-term plan. It allows you to make better asset allocation.
For instance, let’s say given instruments reap great long-term return but has a high probable maximum loss. Now, you must decide if you are willing to bear the loss, if it comes, on the chance of earning great returns in the future.
Generally, a professional with expertise in asset valuation can help you in drafting the maximum loss plan. If you know the fundamentals of finance, you can also calculate the value.
- Implement Dollar-Cost Averaging
If you are a newbie in the world of investing, you might make the mistake of investing a large sum of money in one go. To minimize downside risk, it is better to invest a fixed amount in an instrument at every regular interval. This interval can be bi-yearly, quarterly, or monthly.
For instance, let’s take mutual funds as an example. You have $40,000, and you wish to invest it all in mutual funds. Either you can choose to invest it all in one go, or you can periodically invest over time. This will protect your investment against unforeseen market conditions.
Not only does this spread the downside risk over time, but it also helps in automating your investment portfolio. It allows you to set up recurring purchases periodically. This way, you don’t have to constantly remember to invest. Instead, different tools do it for you.
- Diversify across market capitalization
Portfolio investment is all about spreading your money over an array of portfolios. This automatically helps in reducing risk. When it comes to choosing the constituents of your portfolio, one way to choose is by diversifying across market caps.
Market Capitalization is the cumulative value of every publicly traded share of a given company. For instance, let’s say a company has 200,000 shares outstanding. At a share price of $5, the market cap would be $1,000,000. This signifies the size of the given company.
Generally, large-cap firms are large companies, while small-cap firms are smaller enterprises. While large-cap firms offer stable stock value, they also feature slow growth and less risk of collapse. On the other hand, small-cap companies offer high growth, but also a high risk of collapse.
You might think that investing in large-cap firms is the right choice. However, for optimum returns along with minimized risk, it is advised that you diversify and choose a mixture of large-cap firms and small-cap firms.
This way, you will be able to balance off the risk of small-cap firms with the stability of large-cap firms. While you are at it, there are various tools that can help you in this regard. For example, Zigmma is an investment portfolio software that can help you track the health of your investment and make informed decisions.
- Diversify across sectors
At times, some sectors thrive, while others face losses. In 2020, given the unforeseen circumstances, while the Ecommerce industry is soaring, the airline sector is witnessing magnanimous losses, unlike ever before!
Now, had someone solely invested in stocks of airline companies, the chances are that they will be suffering huge losses right now. This would be true despite the fact what the market cap was.
To further cushion your investment against losses, it is a good idea to spread your money across different industries. Choose sectors that are known to be stable. Here, utility stocks and essential business stocks will be the right choice.
Once you have enough stable stocks to cushion a blow from high risk but high return stocks, you can go ahead and invest in some volatile industries like the tech sector.
Parting Advice: Only speculate what you can afford to lose
There are certain instruments and securities that offer minimal risk. While they don’t offer great returns, they are security of the future. This includes retirement funds.
Apart from such instruments, there are stocks that are meant for speculators who wish to make quick money. In this world, the risk is high, and so are the returns.
If you choose to enter this realm of the investment world, make sure to only invest money you can afford to lose. Don’t invest your life savings in volatile and risky stocks. Here, you never know whether you will gain or lose!
Make your portfolio and invest!
Now that you know how to minimize downside risk, you are ready to invest. Create a portfolio. Spread it across sectors and market caps. Know the probable maximum loss of each instrument you invest in. Invest a little over a long time.