How to reduce your investment risk

There are several strategies you can use to ensure you're not taking on too much risk with your investments.

Regardless of how you choose to invest your money, from trading it in the share market to keeping it tucked away in a bank account, there are risks involved. This guide will take you through the different strategies you can use to reduce your risk when investing.

What is investment risk?

Investment risk is the risk of financial loss. All investments carry some level of investment risk. When you decide to invest your money, it's never guaranteed that you'll make a return on that money. In fact, you could even stand to lose the money you initially invested (and sometimes more, if you're trading products like CFDs).

Thankfully, there are many ways to reduce the level of risk you take on when investing.

Strategies to reduce your investment risk

You can use one or a combination of the following strategies to help reduce your risk when investing. The more of these strategies you use, the more you'll reduce your investment risk.

Understand the different asset classes

The first and probably most vital step to reducing your investment risk is understanding what it is that you're investing in. It's important to understand that different investments can be categorised under different asset classes, and each asset class comes with a different level of risk.

For example equities, which includes Australian and global shares, are often thought to be the most high-risk of all asset classes, usually followed by property. On the other hand, cash, which includes bank deposits in products like savings accounts or term deposits, is seen as the least risky asset class, followed by fixed interest (e.g. corporate bonds).

Understanding the asset classes will help you design an investment portfolio that matches the level of risk you're comfortable with. You can read our detailed guide to investment asset classes here for more information on each individual asset class.

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Diversification between asset classes

To avoid putting all your eggs in one basket, one simple way to reduce your risk is by diversifying your investments across a range of asset classes. This is because each asset class behaves differently. For example, if the property market is doing poorly, it's possible the share market could be performing strongly (or vice versa). If you're only invested in one asset class, and that asset class does poorly, your entire portfolio will suffer.

You don't need to invest in every asset class, but making sure you're invested in more than one or two different asset classes will help reduce your risk. The amount you invest in each asset class will also depend on the amount of risk you're happy to take on.

For example, let's say you wanted to take on a moderate level of risk. That is, you're happy for some of your investments to be high-risk, but you don't want your entire portfolio to be. You might decide to invest a third of your money in equities, a third in property and a third in cash. If you were striving for a very low level or risk, you could reduce this to be only 10 to 20% of your money in equities, and the rest in fixed interest and cash.

Diversification within asset classes

It's also important to diversify your investments within each individual asset class. So with the portion of your portfolio in equities, make sure you're invested in a range of different types of shares. You can invest in shares from different sectors like healthcare, financials and resources as well as different countries like Australian shares and US shares.

If you're keen to invest in US stocks, read our guide on how to buy shares like Netflix, Google and Amazon in Australia.

Balancing risk and reward

It would be nice if you could earn high returns while taking on little risk, but unfortunately investing doesn't work this way. It's typically understood that the higher the risk, the higher the potential reward. This means that in order to earn a return on your investment, you're going to need to take on a certain level of risk.

It's fine to exclusively invest in low-risk products like savings accounts, but you won't get a very big return on your money by doing this. On the other hand, investing exclusively in high-risk shares could have the potential to get you much higher returns, but you're also taking on a much higher level of risk in exchange.

To find the right balance, it's a good idea to start from the outcome you're hoping to achieve with your investments. Try to figure out what success looks like for your portfolio, then work backwards to determine what investments you'll need to make to get there and how much risk you'll need to take.

Investing for the long term

Another way to reduce your risk is to invest with a long-term mindset. Investments, like shares, can be very volatile, often rising and falling by a significant amount in the space of a month or less. But if you're invested for the long term, say 10, 20 or even 30 years, you won't be as bothered by short-term market movements. A lot of higher risk share portfolios predict they'll achieve their objective (i.e. they'll achieve the high returns that they're aiming for) after 7-10 years, despite a lot of ups-and-downs along the way.

The dollar cost average strategy

The dollar cost averaging strategy is a way of buying small parcels of the same asset gradually over time, rather than buying it all at once. For example, let's say you wanted to invest $20,000 into The Smith Company. Instead of buying $20,000 worth of The Smith Company shares in one hit, you could buy $2000 worth of the shares each month for 10 months.

This means that you're not having to pick a certain share price to buy your shares, which opens you up to the risk of buying them at a bad price. Instead, by buying the shares in The Smith Company in smaller parcels over a longer period of time, the average price of your shares will be a lot more accurate and closer to the true value of the shares.

This strategy helps reduce the risk of buying the shares at a bad price; however, it does mean that you'll pay more in brokerage fees as you'll need to pay brokerage on each trade. For this reason, the dollar cost average buying strategy is more worthwhile when you're investing large amounts of money.

Research before you invest

It may go without saying, but one of the main strategies to reducing your investment risk is to do your research. Investing in assets with little thought, or investing in something based on rumours or speculation from others, is a sure-fire way to increase your risk.

Here are a few easy ways to research potential investments:

  • Watch the news. Make a habit of reading the financial news in the morning or listening to the market updates on the radio on your way to work. You'll get updates about the economy and how different asset classes are performing.
  • Read the product disclosure statement (PDS). Each investment product will offer a PDS online that's free for anyone to read. The PDS will outline how the product works and includes all the fees you need to be aware of.
  • Read annual reports. If you're investing in shares, read the company's annual reports to get an idea of how the company is performing and what its plans are for future years.
  • Do online research. You can access more comprehensive guides on different aspects of investing via our investing hub here.

How much investment risk should I take on?

Everyone will be comfortable with different levels of risk, and you might find that you're actually comfortable taking on a lot more risk than you think you are. Or, you might think you're fine with risk but discover that you're actually quite risk averse. This is why it's a good idea to learn your risk profile.

Your risk profile is an outline of your personal risk tolerance and your attitudes towards taking risks. It's similar to a personality profile that might determine if you're introverted or extroverted. A risk profile questionnaire will ask you a series of questions to help determine how risk averse you are, what stage of life you're in and how much investment knowledge and expertise you have.

If you opt for a personal financial planner, they'll ask you to complete a risk profile questionnaire before designing your investment portfolio for you. If you're designing your own portfolio, you can find plenty of free risk profile questionnaires online. You're not forced to invest in line with your results, your risk profile is merely a guide.

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