How to Reduce Investment Risk

If you lay awake at night worrying about your investments, they are probably too risky for your investment temperament.

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Your individual investments can typically be summed up in two words: "risk" and "reward." The general rule of thumb is the greater the potential reward, the greater the risk. But that rule doesn't always hold true in reverse order -- greater risk doesn't necessarily translate into greater potential reward. Sometimes greater risk is just greater risk with little potential reward. Risk isn't a bad thing. But you need to understand what kind of risks you are willing to take with your investment dollars, and how to reduce unacceptable levels of risk.

Step 1

Determine your tolerance to different kinds of risk. Every investment involves some level of risk. Understanding the type of risk, or the combination of types of risk, is essential in reducing those risks. Two factors that can help you determine your risk tolerance are your net worthe and your risk capital. Your net worth is your assets minus your liabilities. Your risk capital is money that, if you lose on an investment, won't impact your lifestyle. If you have a high net worth and substantial risk capital, you can afford to have a higher risk tolerance. If your net worth is little or nothing, and you don't have much risk capital, you probably will be better off with conservative, low-risk investments.

Step 2

Do your own due diligence. In a nutshell, that means research your investments before you make them. Check out the investment's history, earnings growth, management team and debt load. Compare the results with other similar investment products as well as to other assets in your investment portfolio. One metric you should keep an eye on is a stock's price-to-earnings ratio, or P/E ratio. It measures the relationship between a company's stock price and its annual after-tax earnings. A company with a significantly higher P/E ratio than other comparable companies in the same industry typically involves a higher risk. You can reduce your investment risk by weeding out stocks with high P/E ratios, unstable management and inconsistent earnings and sales growth.

Step 3

Diversify your investment portfolio across investment product types and economic sectors. Diversification reduces your overall risk by spreading it over a variety of products. For example, you might consider putting 25 percent of your investment money into XYZ stock, 25 percent into an FDIC-insured certificate of deposit, 25 percent into U.S. Treasury bonds and 25 percent into real estate. If XYZ takes off, you'll make a profit, but your profit potential is reduced because only a portion of your money is invested in the stock. If XYZ tanks, your loss is also limited, because 75 percent of your money is invested in other products.

Step 4

Monitor your investments regularly and reallocate your resources as necessary. The proper allocation of your investments depends on such factors as your age, how long you have to invest and your investment temperament. For example, a conservative investor might have 40 percent of his portfolio in intermediate-term bonds, 25 percent in large cap stocks, 10 percent in short-term bonds, 10 percent in mid-cap stocks, 10 percent in small cap stocks and 5 percent in international stocks, according to the American Association of Individual Investors. Once a year you should evaluate your holdings and buy or sell assets as necessary to bring your portfolio back to proper asset allocation.

Step 5

Take advantage of investment products guaranteed by the federal government. For example, the Federal Deposit Insurance Corporation insures your deposits at member banks, including certificates of deposit and money market accounts, up to $250,000 as of 2012. The National Credit Union Administration provides the same insurance for similar deposits at federal credit unions. U.S. Treasury securities, including U.S. savings bonds, are not insured by any federal agency, but they are backed by the full faith and credit of the United States government. While there are still market risks and early withdrawal penalties if you have to access your money prior to maturity, the principal and interest of these investments are as safe as you can get when held to maturity.