Usually when speaking on investors risk we think of it as the probability of losing part or all of our investment but more general definition for risk will be the chance that an investor will not meet his financial goals. We can look at risk in two different ways:
Chances of losing some or all of the original investment.
Chances of not meeting our return target.
After we defined the risk more clearly we can deal with each aspect of it in a specific way. First let’s try not to lose. We will take the following measures to reduce the chances of losing big part of our investment:
1. Diversification: Never put all your eggs in one basket, even if you are completely sure you found the holy grail of investments. Diversified assets should exhibit low or negative correlation (Known also as hedging with risk parity) to one another for example stocks and long term treasuries. An example of bad diversification would be holding a portfolio of few stocks from the same sector/industry. You can diversify between stocks, real estate, commodities, bonds, treasuries, futures, options, forex etc. but it would be more wise and easy to diversify between no more that 5-6 asset classes. I consider hedging as part of diversification with low/negatively correlated assets, so for example buying long term treasuries and hedging for inflation using gold is considered as diversification. You can also use geographical diversification like holding equity of emerging and developed markets in different locations, but you need to remember it exposes you to forex exchange risks, for example you can hold a strong stock with positive momentum in the Japanese market but if the Yen (JPY/USD) is becoming weaker you can end up losing.
2. Timing: Find a strategy that will help you successfully time the asset price movement and keep you safely out from big moves that can reduce your equity substantially. Note that not all assets can be timed successfully and even if it can be timed it is not always a simple task. Another thing to understand is that we cannot predict asset prices, at least not for the long term, but we can let the price and fundamental data show us the direction where we have better chances of winning.
3. Liquidity: Holding assets with low liquidity can be more risky since we can have a problem when trying to get out of the position, so even if you find value, momentum or any other edge in low liquidity asset think twice before entering the position.
4. Volatility: High volatility assets tend to be more risky then low volatility assets, before taking this risk be sure that the risk is compensated with higher expected returns.
After briefly learning how to keep our money safer we need to learn how to make it work for us and meet our expected return goals (reasonable return goal..) :
1. Taking the risk and the reward: Over conservative investors should understand that not taking risks (for example holding 100% short term treasuries) will not be very beneficial in the long run. In order to keep pace with inflation and also gain some real benefit of your hard earned money you have to take the risk of holding non cash assets, the compensation of taking this risk will usually be higher reward on the long run. Of course we need to choose carefully what risk we are willing to take and what is the reward we expect, for example we can set a goal of 10% annual return and 15% maximum portfolio drawdown, and then look for ways to implement this targets.
2. Limit your hedging weight: Your hedging position might help you reduce the overall risk in your portfolio but they also carry a cost which results in overall lower return. For example holding few stock and buying put options or short futures on the market will definitely reduce the market risk component of your stock portfolio but you will pay the cost of holding an hedging position that decrease in value on the long run and on top of this you will have less available money to put on the desired stock equities. Generally I do not believe in hedging with instruments that have high costs like put options and market shorts, I rather buy bonds and treasuries that also pay some interest to the holder although they do not have the perfect negative correlation that we seek in hedging positions.
3. Find a strategy with an edge and stick to it: If your target is to outperform the general market you need to do your share of investigation and find yourself a time proven strategy that has some edge on the market , you can use value investing , momentum , trend following, sector rotation , timing etc. The most important thing is once you found a good reliable strategy, stick to it, do not jump from one strategy to another, and do not let your greed/fear emotions run your investment decisions.