Risk Mitigation Strategies
Knowing about investment risks is only half the equation. Investors and financial professionals must also understand how to manage and mitigate these risks. This section covers the key strategies for reducing both systematic and unsystematic risks in a portfolio.
Overview of Risk Mitigation
| Risk Type | Primary Mitigation Strategy |
|---|---|
| Unsystematic risk | Diversification |
| Systematic risk | Asset allocation, hedging |
Diversification: The Foundation
Diversification is the most fundamental risk management strategy. It works by spreading investments across many securities so that the performance of any single holding has less impact on the overall portfolio.
Types of Diversification
| Strategy | What It Reduces |
|---|---|
| Across securities | Individual company risk |
| Across sectors | Industry-specific risk |
| Across asset classes | Stock market risk |
| Across geographies | Country-specific risk |
| Across time | Timing risk |
Effective Diversification Requires
- Different sectors and industries
- Mix of company sizes (large, mid, small-cap)
- Domestic and international exposure
- Multiple asset classes (stocks, bonds, real estate)
Key Point: True diversification means holding investments that do not move together. Owning 20 tech stocks is not diversified.
Asset Allocation
Asset allocation is the process of dividing investments among different asset classes based on investment goals, risk tolerance, and time horizon.
Asset Classes
| Asset Class | Risk/Return | Role in Portfolio |
|---|---|---|
| Stocks | Higher | Growth |
| Bonds | Moderate | Income, stability |
| Cash | Lower | Liquidity, safety |
| Real estate | Moderate-High | Diversification, income |
| Commodities | Variable | Inflation hedge |
Strategic vs. Tactical Allocation
| Approach | Description | Time Frame |
|---|---|---|
| Strategic | Long-term target allocation | Years |
| Tactical | Short-term adjustments | Months |
Sample Asset Allocations
| Investor Type | Stocks | Bonds | Cash |
|---|---|---|---|
| Aggressive | 80-90% | 10-20% | 0-10% |
| Moderate | 50-70% | 30-40% | 0-10% |
| Conservative | 20-40% | 50-60% | 10-20% |
Hedging Strategies
Hedging uses one investment to offset potential losses in another. Unlike diversification, hedging directly targets specific risks.
Common Hedging Tools
| Tool | Use Case |
|---|---|
| Put options | Protect against stock decline |
| Call options | Generate income, cap upside |
| Futures | Lock in prices for commodities |
| Short selling | Profit from or hedge against decline |
Protective Strategies Review
| Strategy | Components | Protects Against |
|---|---|---|
| Protective put | Stock + long put | Stock price decline |
| Covered call | Stock + short call | Partial downside |
| Collar | Stock + put + short call | Significant loss |
Dollar-Cost Averaging
Dollar-cost averaging (DCA) is investing a fixed amount at regular intervals regardless of price.
How DCA Works
| Month | Amount Invested | Share Price | Shares Purchased |
|---|---|---|---|
| 1 | $500 | $50 | 10 |
| 2 | $500 | $40 | 12.5 |
| 3 | $500 | $60 | 8.33 |
| Total | $1,500 | Avg: $50 | 30.83 |
Average cost per share: $1,500 ÷ 30.83 = $48.65 (lower than average price)
DCA Benefits
- Removes emotion from investing
- Reduces timing risk
- Buys more shares when prices are low
- Creates consistent investing habit
Rebalancing
Rebalancing is periodically adjusting portfolio holdings back to target allocation.
Example of Rebalancing
| Asset | Target | Before Rebalance | After Rebalance |
|---|---|---|---|
| Stocks | 60% | 70% | 60% |
| Bonds | 40% | 30% | 40% |
When to Rebalance
- Calendar-based: Quarterly, semi-annually, annually
- Threshold-based: When allocation drifts by 5%+ from target
Benefits of Rebalancing
- Maintains intended risk level
- Forces "buy low, sell high" discipline
- Prevents overexposure to any asset class
Liquidity Management
Maintaining appropriate liquidity helps manage the risk of forced selling.
Emergency Fund Guidelines
- Hold 3-6 months of expenses in liquid assets
- Ensure access to cash without selling investments
- Prevents selling during market downturns
Time Horizon Matching
Time horizon is the expected length of time before funds are needed.
Matching Investments to Time Horizon
| Time Horizon | Appropriate Investments |
|---|---|
| Short (< 3 years) | Cash, CDs, short-term bonds |
| Medium (3-10 years) | Balanced mix of stocks and bonds |
| Long (10+ years) | Higher stock allocation acceptable |
Key Point: Longer time horizons can tolerate more volatility because there is more time to recover from downturns.
Summary: Matching Strategies to Risks
| Risk | Mitigation Strategies |
|---|---|
| Market risk | Asset allocation, hedging |
| Interest rate risk | Laddering bonds, duration management |
| Inflation risk | TIPS, stocks, real assets |
| Business risk | Diversification across companies |
| Currency risk | Hedged international funds |
| Liquidity risk | Maintain emergency fund |
| Timing risk | Dollar-cost averaging |
Key Takeaways
- Diversification is the primary tool for reducing unsystematic risk
- Asset allocation manages systematic risk exposure
- Hedging provides targeted protection against specific risks
- Dollar-cost averaging reduces timing risk
- Rebalancing maintains intended risk levels
- Match investment time horizon to appropriate securities
- No strategy eliminates all risk—only manages it
Which strategy is MOST effective for reducing unsystematic risk?
Dollar-cost averaging helps reduce:
An investor rebalances their portfolio from 70% stocks/30% bonds back to their target of 60%/40%. This strategy helps to: