Spreading out your investments to reduce risk is a strategy that successful investors utilize
As an investor, are you good at spreading out your investments to reduce risk? It’s a key component to being a successful investor.
Successful investors never “go for broke,” as the saying goes. Instead, they try to arrange their portfolios so that they profit more or less automatically over long periods. You do that by tapping into the long-term growth that inevitably comes to well-established companies when they operate in relatively free economies during relatively prosperous years and decades.
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Spreading out your investments to reduce risk by sector
Your portfolio strategy should begin with a fundamental piece of advice that we underline frequently. Spread your money out across most if not all of the 5 main economic sectors (Finance, Utilities, Manufacturing, Resources, and the Consumer sector). The proportions should depend on your objectives and the risk you can accept. The Finance and Utilities sectors involve below-average risk. Manufacturing and Resources tend to be riskier, and the Consumer sector is in the middle.
Spreading out your investments to reduce risk is aligned with our three-part Successful Investor investing philosophy
Our Successful Investor approach automatically limits your involvement in notoriously trouble-prone areas like new issues, start-up companies and illiquid investments. Of course, you also need to stay out of companies when you have doubts of any sort about the integrity of insiders. You need to recognize the special risks of investing in fashionable or excessively popular minefields, such as Internet stocks in the late 1990s, or income trusts in the previous decade, or green energy in the current decade. We try to alert you to these kinds of risks in our publications, particularly our Inner Circle.
Rather than avoiding high-risk areas, however, many beginning investors feel drawn to them. That’s because trouble-prone areas always manage to give some investors the mistaken impression that they can generate big and easy profits. Unfortunately, the risks are even bigger.
Spreading out your investments to reduce risk means avoiding the heaviest risk possibilities
Many investors take on heavy risk in hopes of quickly reversing the losses they experienced during market turbulence. It’s a tempting stock market strategy in turbulent situations.
You may have noticed a lot of ads for courses in online, short-term stock trading or foreign-exchange trading. The promoters are aiming their pitch at inexperienced investors who have suffered heavy losses. These investors may be inclined to follow the example of desperate gamblers who bet their last few dollars on a handful of lottery tickets, or a long shot at the track or the casino.
That’s a particularly wasteful example to follow, when so many well-established stocks trade at low multiples of earnings and offer high dividend yields.
Spreading out your investments to reduce risk should not involve buying low-risk, low-return, high-fee structured investments
Financial institutions create these often-complicated investments because they think they’ll be easy to sell to investors.
Structured investments often focus on reducing risk. That’s a huge selling point. But it costs money, which comes out of investors’ pockets. Structured investments can spend so much money cutting risk that they produce scant returns or even losses after five or even 10 years.
The gains you need to offset losses
When they are just starting out, many investors believe they can afford to take big risks with their money. After all, if they lose money, they have decades to break even. But they overlook the way that simple arithmetic works against you when you take on too much risk.
- If you lose 10%, you need an 11% gain to break even.
- If you lose 20%, you need to make 25% to break even.
- If you lose 40%, you need to make 66.6% to take you back to where you started.
- If you lose 50%, you need a 100% gain to break even.
An 11% gain is relatively common; in fact, the market has gained nearly that much annually, on average, over the past 75 years or so. A 25% gain is a little harder to achieve. You need an above-average year to make that kind of return.
Gains of 66.6% to 100% or more can take years. Even if you make enough money to regain your losses, however, that only brings you back to where you started. You’ve still lost some purchasing power to inflation. But in addition, you’ve lost the time value of your money. You’ve missed out on the compound profit you would have made on your original stake and your profits if you had invested more conservatively and made modest gains of perhaps 5% to 10% annually.
Of course, even the highest-quality, best-established stocks go down when the general market is falling. The difference is that top-quality stocks tend to recover and eventually go on to new highs. Meanwhile, they generally keep paying dividends.
Some investors prefer to focus all of their money in one sector that they feel comfortable with. What do you think of this strategy? Have you tried it before?
Have you taken any big risks on an investment? How did it work out?
This article was originally published in 2017 and is regularly updated.