Chapter 4: Managing Risk

Every investment vehicle carries some level of risk – not just the possibility that you won’t turn a profit, but that you can lose some or even all of what you put in to it. You can manage risk, though, with a few proven techniques.

Asset Allocation
The first step in managing risk is to practice asset allocation. This means having some of your money in a variety of asset classes, which include cash, stocks, and bonds. Doing so is a protective measure – typically when stocks are doing well, bonds aren’t, and vice versa. Having some money in cash is a protective measure too – outside of inflation risk, you can’t really lose principal.

Generally speaking, cash is the least risky of the asset classes, then bonds, and then stocks. Where you put your money depends largely on what type of investor you are, so be sure to allocate your funds according to your comfort level and needs:

Aggressive Investor 75% of holdings in stocks 15% in bonds 10% in cash equivalents	Balanced Investor 50% of holdings in stocks 25% in bonds 25% in cash equivalents	Conservative Investor 25% of holdings in stocks 25% in bonds 50% in cash equivalents

Diversification
After you spread risk by investing in different asset classes, you can reduce it even further through diversification. There are many different types and classes of stocks and bonds – some are much more risky (but with the potential for greater reward) than others. Therefore it is a good idea to divide your funds among a variety of investment vehicles with different risk and reward potentials.

An easy way to diversify your holdings is with mutual funds, since they are comprised of many different investment types and classes.

Dollar Cost Averaging
Dollar cost averaging is another way of managing investment risk. You can practice dollar cost averaging by purchasing securities with a fixed amount of money at regular intervals. This way you buy more shares when the price is low and fewer shares when the price is high, thus reducing the over-all cost of the shares purchased.