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The dimension with which we measure the risk of an investment asset and, by extension, of an investment portfolio (which is the set of financial assets in which you invest) is volatility. As we have seen on other occasions, volatility cannot collect all the risk, but a significant part, and it is also the standard measure that allows us to know how risky an asset is compared to the market average or other assets.
A well-diversified investment in stocks usually has around 20% volatility and fixed income (mainly sovereign fixed income) around 5%. From there we can compare.
Those of us who started investing before the last great crisis have the psychological anchor of this one, and the great drops (drawdowns) and their prolongation in time are always very present in our minds. It is what destroys personal psychology from a financial point of view and what makes you quit.
The great crises mark generations and establish guidelines of good sense and caution that are absolutely necessary for the operation of a personal investment system that lasts a lifetime.
This has the problem that we bias ourselves towards the risks that may occur and build investment portfolios that lose profitability for years. True. But in this way, you never give up, or the chances of doing so are reduced.
A person with a mediocre but relatively stable system of returns does not quit, one who establishes a very high system of performance but without taking into account the worst-case scenarios, if he does so and at the moment.
The challenge is to combine them.
For this, we are going to see four simple ways to reduce the risk of our investment portfolio, whose objective is not to abandon, and continue investing, so that our personal financial assets continue to grow little by little so that they respond for us in the last third of our lives, which are going to be longer and longer.
Don’t complicate your life
Make it as simple as possible. The more complexity, the more hidden or difficult risk to control. You can set new rules, but keep them simple.
There are complex strategies for hedging against large falls, which use large funds or professional operators, such as the use of options, futures, etc.
You do not need it and it is also not within your reach.
The easiest way to reduce the risk of your portfolio in the event of a pronounced and/or prolonged possible fall is to reduce the percentage you have in equities (stocks) and invest in fixed income that has little risk.
A simple 50/50 rule with half in Stock Exchange and the other half in high-quality bonds.
The counterpart is that in the very long term (more than 15 years) you would have lost profitability. This is the cost of security.
Everything has a cost. You have to know what cost you want to bear and what cost you can bear.
Invest in other “uncorrelated” assets
When we say “uncorrelated” we mean that they do different things (returns), not that they have different names. In other words, there are different assets, but they are not really unrelated.
This is a fact increasingly common to many types of assets listed because of the monetary policies of central banks (and financial and technological globalization itself) that are making everything increasingly correlated.
Is the real estate market uncorrelated with stocks? Are emerging markets uncorrelated with more developed markets? Not too much.
Obviously many things can be nuanced here, but if we talk about reducing a simple portfolio by a non-expert person in a simple way, we will simplify everything a little.
I have always insisted on investing in alternative assets (or alternative investments), real assets. Assets that are outside the secondary markets, which due to not being listed are already de-correlated; natural resources, intellectuals, financial needs in other countries, new technologies, concrete raw materials, intangibles … you can build fantastic investment portfolios, understanding and experiencing their evolution.
For example, solar energy and its relationship with ecology, new industries such as video games, and its relationship with the change in leisure behavior of new generations, wood and the growth and ecosystem of forests, finance marketers from countries emerging, and understand how online business works and a long etcetera. It is pretty, really.
The volatility of real estate is higher (although its profitability too) and in the case of emerging companies, the same thing happens. If we include them it is because we want to have better profitability in the long term, but if what we are talking about is reducing risk, they do not reduce it but increase it.
Expand the time horizon
There is a basic fact that is often not understood; the money you invest in an investment portfolio is money you do not need (except for a very exceptional fact). If you need it, you need not invest it.
The time horizon is the time for which you program your investment; if we extend it, volatility is reduced, because the large movements, the great falls, in a greater temporal computation are diluted.
A daily investment would be the most random, risky, and chaotic there is. If we extend it to 1 year it is drastically reduced, if we also extend it to 10 years everything changes completely.
Furthermore, if the portfolio you make is not for at least 10 years, with a vital perspective, it is better not to do it. Over time, you stop looking at it and let it work.
Increase your liquidity position
Liquidity as a strategic position of an investment portfolio is one of the things that is least understood.
Here we would enter something a little more active, but hyper simple.
Let’s go to the first point and instead of having 50% in bonds, you have 50% in liquidity, for example, in bank deposits.
If you think that difficult times are coming, go liquid and leave the rest of the portfolio to work. You will lose profitability, but you will dramatically reduce portfolio risk.
As you can see, there are four hyper-easy ways to dramatically improve a portfolio’s risk. Then this can be improved, but these ways are very effective.
Contributed by Jonathan Veers, the Founder of SPV Company Mortgages. As a specialist mortgage broker with over 10 years of industry knowledge, he has helped experienced landlords and first-time investors across the country; save tax, time, and money by tracking down the best ownership structure and most competitive rates.