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All investing involves some level of risk, and how much any individual investor is willing to take on will depend on their risk tolerance. There are also numerous investment risk strategies out there that they can use to try and limit losses while pursuing returns.

But it all comes down to the specific investor. Some have higher risk tolerances, and think less about investment risk management than others. Either way, investors can take measures to help protect themselves against the inevitability of a correction or a bear market by using various risk management strategies.

What Is Investment Risk Management?

Risk management, in investing, refers to the attempt to reduce the amount of risk within a portfolio. It’s important to realize that you’re never going to completely rid yourself of risk; every investment, no matter how “safe” it’s claimed to be, is risky to some degree. But there are strategies that investors can use to try and reduce the risks that might threaten the value of their portfolio.

In a similar vein to how businesses attempt to manage risks to their operations, investors try to manage risks as well. There are some basic and broad strategies for doing so, such as dollar-cost averaging or diversification, along with some more targeted and specific strategies.

How to Quantify Risk

Quantifying risk can be tricky, as measuring something that is somewhat unmeasurable by normal methods is difficult. But financial professionals do spend a lot of time and resources finding ways to measure both quantitative and qualitative risks for investors.

Some of the factors that are taken into account when quantifying risk include volatility, but for individual companies and stocks, there can be any number of risks related to credit, interest rates, metrics related to the strength of the broader economy, and more.

Common Risk Management Techniques

As noted, perhaps the simplest and most common risk management techniques for investors are dollar-cost averaging, and diversification.

Dollar-cost averaging, in practice, involves investing relatively small amounts of money or capital over a long period of time. That means an investor is buying at different prices, and over time, the cost basis averages out, rather than buying at a lump-sum single price.

Diversification, further, involves buying a wide range of investments, including different types of securities, from different industries and different geographies. Theoretically, a well-diversified portfolio may be cushioned from steeper losses if a single industry suffers a decline. But, of course, there are no guarantees with investing.

Calculating Risk Tolerance

Before learning more about the numerous risk management strategies out there, it can be helpful to get a deeper understanding of the level of risk a person is comfortable taking when building an investment portfolio.

That includes thinking deeply about an investor’s risk tolerance, which is usually determined by three main factors:

Risk capacity: How much can the investor afford to lose without it affecting actual financial security? Risk capacity can vary based on age, personal financial goals, and an investor’s timeline for reaching those goals.

Need: How much will these investments have to earn to get the investor where they want to be? (An investor who is depending heavily on investments may be faced with a careful balancing act between taking too much risk and not taking enough.)

Emotions: How will the investor react to bad news (with fear and panic? or clarity and control?), and what effect will those emotions have on investing decisions? Unfortunately, this can be hard to predict until it happens.

So, why is risk management important? Those who are able to preserve their capital during difficult periods will have a larger base to grow from when the market regains steam. With that in mind, here are some strategies investors sometimes use to manage the risk in their portfolio.

Basic Risk Management Techniques

As noted, there are some relatively basic risk management techniques for investors to use, such as diversification and asset allocation — but there are several others, too.

1. Reevaluating Portfolio Diversification and Asset Allocation

You’ve probably heard the expression “don’t put all your eggs in one basket.” Portfolio diversification — a strategy involving allocating money across many asset classes and sectors — could help with avoiding disaster in a downturn. If one stock tanks, others in different classes might not be so hard hit, as noted.

Investors might want to consider owning two or more mutual funds that represent different styles, such as large-cap, mid-cap, small-cap, and international stocks, as well as keeping a timeline-appropriate percentage in bonds. Those nearing retirement might consider adding a fund with income-producing securities.

But investors should beware of overlap. Investors often think they’re diversified because they own a few different mutual funds, but if they take a closer look, they realize those funds are all invested in the same or similar stocks.

If those companies or sectors struggle, investors could lose a big chunk of their money. Investors could avoid overlap by simply looking at a fund’s prospectus online.

To further diversify, investors also may want to think beyond stocks and bonds. Exchange-traded funds (ETFs), commodities, and real estate investment trusts (REITs) are just a few of the possibilities.

Investors could also diversify the way they invest. For instance, an investor might have a 401(k) through their employer, but also open a traditional IRA or Roth IRA online through a financial company.

2. Lowering Portfolio Volatility

One of the easiest ways to help reduce the volatility in a portfolio is to keep some percentage allocated to cash and cash equivalents. This may keep an investor from having to sell other assets in times of need (which could result in a loss if the market is down).

The appropriate amount of cash to hold may vary depending on an investor’s timeline and goals. If too much money is kept in cash for the long-haul, it might not earn enough to keep up with inflation.

There are other options, however. Here are a few.

Rebalancing

The goal of portfolio rebalancing is to lower the risk of severe loss by keeping a portfolio well-diversified. Over time, different assets have different returns or losses based on the movements of the market. Rebalancing helps get things back to the mix the investor wants based on personal risk tolerance.

Rebalancing can often feel counterintuitive because it can mean letting go of investments that have appreciated in value (the ones that have been fun to watch) and buying investments that are declining in value.

Forgetful investors may even be able to sign up for automatic rebalancing. Without rebalancing, a portfolio’s mix may become stock heavy or sector heavy, which may significantly increase risk.

Buying bonds

Unless investors are regularly rebalancing their portfolio (or are having it done automatically), their mix may be skewing more toward stocks than they think. Those who are concerned about market volatility might want to rebuild the bond side of their portfolio.

Bonds might not be completely safe investments, but bonds with a lower duration can still play a defensive role in a diversified portfolio. And bonds often can be used to produce a steady stream of income that can be reinvested or used for living expenses.

Municipal bonds can generate tax-free income. Bonds, bond ETFs, and treasuries can all serve a purpose when the market is going down.

Beta

The beta of a stock is a measure of the interrelationship between the stock and the stock market. A beta of one, for example, means the stock will react in tandem with the S&P 500. If the beta is below one, the stock is less volatile than the overall market.

A beta above one indicates the stock will have a more marked reaction. So, replacing high beta stocks with lower beta names could help take some of the menace out of market fluctuations.

3. Investing Consistently

For those looking for quick returns, picking the “right” stock and selling it at the “right” time is everything. Using a dollar-cost averaging strategy is different. It’s all about patience, discipline, and looking at the long term. And it can help investors keep emotions out of the process.

With dollar-cost averaging, investors contribute the same amount at regular intervals (usually once or twice a month) to an investment account. When the market is down, the money buys more shares. When the market is up, it buys fewer.

But because markets generally rise over time, investors who can keep their hands off the stash might build a pretty nice pot of money over the long-term — especially compared to what they might get from a savings account or money market account.

Some investors hand over their cash every month and don’t pay much attention to where their 401(k) plan administrator or the bank with their IRA might put it. But carefully choosing the companies represented in a portfolio — focusing on those with sustained growth over time — could help make this strategy even stronger.

4. Getting an Investment Risk Analysis

For years, financial professionals have mostly labeled investors’ risk tolerance as “aggressive,” “moderate,” or “conservative.” Those can be fairly subjective descriptions. The term “moderate,” for example, might mean one thing to a young investor and another to an older financial professional.

An investor might not even know how they’ll react to a market slump until it happens. Or a person might feel aggressive after inheriting some money but conservative after paying a big medical bill.

To help with clarity, many in the financial industry are now using software programs that can help pinpoint an investor’s attitude about risk, based on a series of questions. They can also better determine how an investor’s current portfolio matches up to a particular “risk score.”

And they can analyze and stress test the portfolio to show just how the client’s investments might do in a downturn similar to the ones that occurred in 2000 or 2008.

Identifying an investor’s current position and goals might make it easier to create a more effective plan for the future. This could involve identifying the proper mix of assets and realigning existing assets to relieve any pressure points in the portfolio.

Recommended: SWOT Analysis, Explained: Definition and Examples

5. Requiring a Margin of Safety

“Buy low, sell high!” is a popular mantra in the financial industry, but actually making the concept work can be tricky. Who decides what’s high and what’s low?

Value investors may implement their own margin of safety by deciding that they’ll only purchase a stockif its prevailing market price is significantly below what they believe is its intrinsic value. For example, an investor who uses a 20% margin of safety would be drawn to a stock with an estimated intrinsic value of $100 a share but a price of $80 or less per share.

The greater the margin of safety, the higher the potential for solid returns and the lower the downside risk. Because risk is subjective, every investor’s margin of safety might be different — maybe 20%, 30%, or even 40%. It depends on what that person is comfortable with.

Determining intrinsic value can take some research. A stock’s price-to-earnings ratio (P/E) is a good place to start. Investors can find that number by dividing a company’s share price by its net income, then compare the result to the P/E ratio posted by other companies in the same industry.

The lower the number is in comparison with the competition, the “cheaper” the stock is. The higher the number, the more “expensive” it is.

6. Establishing a Maximum Loss Plan

A maximum loss plan is a method investors can use to cautiously manage their asset allocation. It’s designed to keep investors from making bad decisions based on their anxiety about movements in the market.

It gives investors some control over “maximum drawdown,” a measurement of decline from an asset’s peak value to its lowest point over a period of time, and it can be used to evaluate portfolio risk.

This strategy calculates a personal maximum loss limit and uses that percentage to determine appropriate asset allocation, but that asset allocation won’t necessarily be a good fit for someone else. It isn’t a one-size-fits-all plan.

Here are the basic steps:

1.    Based on historic market numbers, the investor chooses an assumed probable maximum loss for equities in the stock market. For example, since 1926, there have been only three calendar years in which the S&P 500’s total return was worse than -30%. The worst year ever was 1931, at -44.20%. So the investor might choose 40% as a probable maximum loss number, or maybe 35% or 30%.

2.    Next, based on personal feelings about market losses, the investor chooses the maximum amount they are willing to lose in the coming year. Again, it’s up to the individual to determine this number. It could be 20% or 30%, or somewhere in between.

3.    Finally, the investor divides that personal portfolio maximum loss number by the assumed probable maximum loss number. (For example, .20 divided by .35 = .57 or 57%.)

In this example, the investor’s target equity asset allocation would be 57% when market valuations are average (or fair value).

The investor might raise or lower the numbers — and be more aggressive or conservative — depending on what’s happening in the market.

Advanced Risk Management Techniques

Beyond the aforementioned risk management techniques, some investors may want to dig a little deeper and use some more advanced tactics. That could include the following.

7. Using Hedging Strategies With Options

For investors who are comfortable with options contracts, which can be difficult to understand and utilize for many investors, there are strategies that can be employed to further try and lower a portfolio’s overall risk profile. For instance, investors can use certain types of options to try and protect their portfolio from sudden price declines and lessen their potential losses.

In many cases, this could entail using a put option strategy that could provide protection against a stock or asset’s price decline. Purchasing a put option effectively gives the investor the “option” to sell an asset for a potential profit if the price falls below a certain level, called the strike price.

However, the investor could see losses if the asset price moves in an adverse direction. Since options are considered a higher risk investment, they’re typically best for experienced investors.

8. Implementing Stop-Loss Orders

Stop-loss orders can also be used to an investor’s advantage if used properly. Stop-loss orders are orders that are fulfilled by a brokerage when certain conditions are met, generally, when a stock or asset’s value hits a certain specified level. In that case, the order is executed, and an investor’s holdings are liquidated without any additional input from the investor.

For instance, if an investor wants to limit their potential losses, they could specify a stop-loss order if a holding loses 10% of its value. In that case, if the asset loses 40% of its value, the investor’s losses are limited to 10%.

9. Understanding Risk-Adjusted Returns

Risk-adjusted returns give investors an idea of both their overall return, and what risks were taken on in order to achieve or generate those returns. This is advanced, as discussed, and may not necessarily be something that most investors worry about. But there are many methods for calculating risk-adjusted returns, and depending on how intricate your investment strategy is, it can be helpful to understand if the risks an investor is assuming is worth the potential return generated.

The Takeaway

Risk management, and implementation of risk management strategies, is critical for most investors. All investments involve some level of risk, and instead of ignoring it, it can be helpful to gauge your individual risk tolerance, and choose risk management strategies that mesh with your tolerance.

Whatever strategy an investor chooses, risk management is critical to attempting to keep potential losses to a minimum. Remember: As losses get larger, the return that’s necessary just to get back to where you were also increases. It takes an 11% gain to recover from a 10% loss. But it takes a 100% gain to recover from a 50% loss. That makes playing defense every bit as important as playing offense.

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FAQ

How does diversification help manage investment risk?

Diversification involves investing in different assets, industries, geographies, and more, and can help manage investment risk by diluting a portfolio’s holdings so that a downturn in one specific area does not lead to outsized losses.

What is the best way to measure investment risk?

It’s difficult to say what the best way to measure investment risk is, but perhaps the simplest could be to calculate standard deviation, which gives an investor an idea of how far from a statistical average or mean an asset’s value could deviate. Note, however, that standard deviation does have its limitations.

How often should I rebalance my portfolio?

How often you rebalance your portfolio will depend on your specific investment goals and strategy, but in general, it may be a good idea to rebalance at least once or twice per year.

What role do bonds play in reducing investment risk?

Bonds may act as a counterweight to stocks in a portfolio, as their values do not fluctuate nearly as much as stocks, and they can be less volatile and subject to market forces. So, a portfolio that is concentrated heavily in stocks may see its value drop or rise with the overall market, but one that is more concentrated in bonds would remain relatively stable.

What are the common mistakes investors make in risk management?

Some common mistakes investors make in regard to managing risk include forgetting or forgoing due diligence, making emotional or kneejerk investment decisions, trying to time the market, and not properly diversifying their portfolio.