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5 Ways to Reduce the Risks of a Financial Investment

When we invest in financial assets, in mutual funds in this case, the first thing that comes to mind is making money. However, just as important as the profits we aspire to build – that is what we invest for, without a doubt – is to take into account the risks we are going to assume, and try to minimize them. The balance between both concepts – risk and profitability – is the true objective of a good investor.

Five tips to reduce the risks of an investment

Diversifying in fixed income, sometimes, is not diversifying.

They taught in the race that, to reduce risk, you just had to diversify properly. Taking it to the most basic, it is about first choosing actions that complement each other – that is, companies that are exposed to different sectors, so that while some take advantage of expansionary economic cycles, others resist much better when the economy goes awry. As average stocks have a high correlation with the market (the famous beta), an equity portfolio may cushion them, but it will not prevent large losses when they occur.

Thus, the theory goes, we must build a portfolio that mixes variable income and fixed income, mainly. We sacrifice a bit of performance, yes, but in exchange, we collect coupons on the bonds in the portfolio, and, more importantly, we benefit from the appreciation that these assets have when the good markets are interrupted. The theory isn’t working this year, and it hardly will.

Fixed income had been chaining price increases for decades , which had taken it to unsustainable levels, and almost non-existent coupons. The withdrawal of stimuli from the central banks suggests that the behavior of this asset will be, in the best of cases, very modest. The only scenario in which they could help portfolios would be in a recession, which would lead to widening credit spreads, negating some of their goodness.

Risks of a Financial Investment

In short, it is to be expected that this time fixed income and equities will be positively correlated (ie fall and rise in unison), and therefore the “traditional” system of diversification will not work. We must diversify, yes, butAlternative strategies must be used more than ever, with little correlation with equities (and with fixed income) that provide real diversification, and allow us to reduce the aggregate risk of the portfolio.

Prepare to be contrarian

With central banks in retreat, and markets more volatile than usual, it is tempting to sell and wait for the storm to die down. This may seem like a very sensible thing to do, but we believe that, in fact, it achieves the opposite of what it should. If we sell when risk increases and buy when things calm down, we will often buy high and sell low, which doesn’t seem like a great tactic for long-term returns.

A server firmly believes that the industry mismeasures risk, and usually identifies it as derived from volatility. In reality, the “real” risk is “definitely losing money”, and it is usually much lower when everyone is selling than when everyone is buying.Basically, because the risk of losing money, when I buy “cheap”, should be less than the risk of losing it if I buy “expensive”, on average. It is not suggested at all to buy whenever others sell. But it is usually very profitable to take advantage of the markets, when prices discount dantesque scenarios, if you have the correct time horizon, and the necessary patience. After the storm, the sun always comes out.

Get to know yourself as an investor to reduce the risk of your investments

The above -taking advantage of the markets, when the time comes- is impossible if you do not know your tolerance for loss, the real availability of what you have invested , and the determination to avoid making irreversible decisions. In other words, the risk of a financial investment cannot be reduced if we do not know ourselves as investors. If we know that we are going to sell if things go wrong, or use money that we may need in the short term, we necessarily have to have a low risk exposure in normal times. Only in this way will we be able to avoid selling at the worst moment, and, with a bit of luck, maybe even be able to buy a little more, when magnificent opportunities really appear.

Inflation is the real enemy to beat

After oneself, of course, as explained in the previous points, our worst enemy is not the market index that we want to beat, it is inflation . Think it through. Saving is just “deferring consumption to the future”. Nothing more. We want to be able to face unforeseen events later, or to pay our expenses when we retire, or to cover our children’s studies.

If we stop consuming today, we will do so at “tomorrow’s” prices. If the profitability that we get from our savings is lower than that of our investments, we are doing a very bad business. We must build a portfolio that reduces the risk of losing, of course, but that is not enough. Having all our money under the mattress exposes us to a sure loss– very bulky these days, by the way.

Mistrust

An investment fund is in itself a very diversified instrument, but it is not true that one is diversified just by being in a fund. You have the risk of the underlying asset, and that of the manager who makes the decisions. The best manager has biases, which sometimes stop working for long periods. We must invest for the long term, and allow a certain strategy to not work for a season. But it is very useful to build a portfolio of investment funds, and not just use a few, because in this way we prevent the decision-making of a single manager from affecting the portfolio too much in the short term.

Also be wary of funds that have disproportionate returns in short periods of time. Usually means taking a lot of risk-remember that risk is not assumed only when prices fall! – and that when things go wrong, the losses are likely to be heavy. It is better never to be the last, than almost always to be the first (it is very difficult to recover from the first).

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