How to Get Rid of Unnecessary Risk When Investing

Although there will always be a risk when investing, you can eliminate a lot of the unnecessary risk by understanding certain key concepts. Deciphering some jargon will help you get started:

  • ASSET ALLOCATION: Your allocation is your mix of asset classes or stocks, bonds, and cash. Why is this mix important? It's a way to balance risk based on the time horizon of your goals, as well as a way to diversify investments (more on this below). This works because each asset class has different risks and rewards and because each asset class typically performs differently in various markets. This can protect investors from losing a large part of their portfolio if one asset category drops significantly.

  • DIVERSIFICATION: Simply put, don't put all your eggs in one basket. By investing in many companies in varying industries, countries, and markets, your risk of all of them decreasing at the same time goes down tremendously. If you own equity in 100 companies and the CEO of one of those companies is charged with a crime, the company’s valuation may go down significantly but that will only negatively affect 1% of your investments. Not too shabby!

Practically speaking, you can do this in a few ways. You can divide your investments across many different companies in different industries and locations. OR, you can make it a whole lot easier on yourself and invest in a fund. A fund is just pooled money that gets invested a certain way. Using funds you can invest in hundreds of companies in different asset classes, countries, industries, and markets just by buying one share. How handy!

There are two main types of funds:

  • PASSIVELY MANAGED: Passively managed funds are also called index funds because they mirror a certain market index (i.e. S&P 500, Dow Jones Industrial Average, Russell 3000, etc.). This means the money going into an index fund will be invested proportionally into individual stocks or bonds according to the percentage they make of that specific index. The Vanguard 500 Fund, for example, mirrors the S&P index. When you invest in an index fund, you are investing in the market and the work is mostly computerized.

  • ACTIVELY MANAGED: The index fund’s counterpart is the actively managed fund. These are managed by an individual manager, co-manager, or a team of managers who choose the investments for the fund based on their investment expertise.

Which is better? That's for you to decide. Yes, some great managers use their expertise to beat the market (aka index funds) but only 2 out 2,862 routinely do! Actively managed funds also typically have higher fees because you are paying for the staff to run them. That's probably why Warren Buffet recommended that Lebron James invest in index funds and also told his own trustee to invest his estate in index funds when he leaves it to his heirs. Thanks, Warren!