3 Tips For Investors to Manage Risk

Investment risk has many definitions -- some define the term as the possibility of losing money, others focus on the opportunity cost when comparing one investment outcome versus another. While both are correct, risk can be defined as the uncertainty (or volatility) of return from an investment during a specified time.

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Behavioral finance tells us that most people prefer to avoid losses than to generate gains and are risk avoiders, not risk takers. Understanding that market declines are normal may help to put periods of market volatility into perspective. Consider:

-- The Dow Jones industrial average has had an average decline of between 5 and 10 percent at least three times per year since 1900. The last time we experienced a decline of this magnitude in recent years was August 2015.

-- Market declines greater than 10 percent, which is considered a market correction, occur on average at least once per year. Again, August 2015 was the last time we saw this type of drop. The average duration of this level of decline from peak to trough is about 115 days.

-- Declines of 20 percent or more, which is considered a bear market, usually occur on average once every three and a half years. The last time that we experienced a correction like this was March 2009. The average duration of this level of decline from peak to trough is a little less than a year.

From these averages and the time that has passed since a meaningful drop, the next market decline could arrive sooner rather than later. This, along with markets reaching all-time highs and the continuous focus on negative news, makes for a stressful environment for investors -- in turn making people very cautious of taking on risk.

Modern portfolio theory suggests that the greater the risk, the greater your return expectation should be on that investment. Conversely, taking little risk or avoiding risk completely will provide little to no return on your investment portfolio, and could likely diminish your ability to attain future goals. Learning to manage risk is critical for long-term investment success. Below are three tips to help stay focused when making investment decisions.

Define your time horizon. Time is a critical factor in making successful investment decisions and a necessary element to weather the storm during market declines. With this in mind, your investment portfolio should be separate from your cash reserve portfolio, which is used to pay for emergency expenses or support your annual spending needs during your retirement years. A cash reserve portfolio has a short time frame and requires predictability of investment returns. For this reason, little risk should be taken with your cash reserve portfolio.

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Your investment portfolio will hold more assets with a high degree of volatility, such as stocks and lesser quality bonds, in order to generate long-term overall return. The longer your time horizon, the more volatility you can withstand.

Utilize dollar-cost averaging. The goal of dollar-cost averaging is to reduce the impact that the timing of investment transactions (typically applies to purchases but can apply to sales) has on performance. By executing a transaction with a constant dollar amount and predefined time, you reduce the emotion involved with trying to time investment decisions. Dollar-cost averaging forces you to execute transactions during high and low market periods, purchasing more shares during down periods, and less shares during high periods forcing a "buy low" discipline. Thus, your average cost per share is lower than the average market price over the same period.

Diversify your investments. When investing, diversification can help to reduce risk. For example, if you own a single stock, you are subject to the risk of bad management as well as industry and demographic changes that could impact a company's stock price. To avoid concentration risk, you should diversify your portfolio across multiple industries and securities. Additionally, diversifying investments across multiple assets classes (U.S. stocks and non-U.S. stocks as well as bonds, real estate investment trusts and commodities) could also help dampen portfolio volatility as each asset class provides its own risk, return and correlation affect to market conditions.

It is vital to remember that the long-term results of a diversified set of investments are not guaranteed. You can invest the exact same way and over booming economic periods (the 1980s and 1990s) your portfolio could grow significantly, while doing the exact same thing over a recessionary period (2000s) may lead to mediocre returns or losses.

[See: 8 Times When You Should Sell a Stock.]

While investment risk will never be eliminated, knowing your time horizon and using strategies like dollar-cost averaging and diversification can help to scale down uncertainty and make you feel less wary about your portfolio. It is also helpful to remember that with risk there can also be reward.

Leslie Thompson, CFA, CPA, AIF, is a blogger for The Smarter Investor blog. She is managing principal at Spectrum Management Group, an Indianapolis-based independent boutique wealth management firm. You can learn more about Leslie and her team by following them on Twitter.