Manage Risk, Realize Profits – Easier Said Than Done?

Risk is an inevitability in investing.  You have to risk money to make money, and the more risk you assume, the greater the potential rewards.  With interest rates the lowest most of us have ever seen, traditional bank accounts and savings accounts fail to beat the rate of inflation, let alone provide a path to true and lasting wealth.

The key is to take calculated risks with your money, based on fundamentals, reasoning and logic.  This may seem simple, until a little thing called emotions get in the way.  Whether it is elation over the next hot IPO, or fear of the next sovereign debt crisis,  emotions can be your number one worst enemy.

So how do you invest with Dr. Spock-like calm, having the nerves it takes to stay the course in a downward market, even buying when everyone else is selling, or not to sell too soon on a momentum play?  Is it possible to remove emotion entirely from investing?  After all, for many of us, our investments represent our life’s savings, our secure financial future and the future of our loved ones – not exactly things that many of us take lightly.

Taking On Calculated Risk And Forget Short-Term Market Volatility

Understanding the role that risk plays in realizing investment gains is only the first step in successful investing.  The next step is to understand how to put that risk to work for you in your portfolio.  You may be surprised to learn that one of the keys to managing short-term market volatility is to ignore it.

It is far too easy to get caught up in the day-to-day drama in the stock market.  By letting the volatility get the best of you, you are actually creating a new type of risk to your investments – the risk that emotion will rule your investment decisions and you will not meet your financial goals.

By obsessing over short-term volatility in the market you run the risk of investing too conservatively, as well as the risk of purchasing or selling a security based on short-term performance rather than how the stock may assist you in reaching your long-term goal of building lasting wealth.

Assess your individual tolerance for short-term volatility, and invest accordingly.  There are specific risks associated with investing, with volatility a byproduct of that risk.  As risks present themselves, volatility results.  While volatility is inevitable, losses are not, and there are ways to successfully manage risk without limiting or wiping out potential profits.

Diversify- But Not Too Much

The classic strategy for risk management and realizing investment gains has been diversification.  This is generally sound advice, as having all of your eggs in one basket could potentially prove to be disastrous if an sector or security were to take a turn for the worse.

There is a risk associated with being too diversified in that you never realize meaningful investment gains with an overly diversified portfolio.  You do not need a portfolio of twenty different stocks and sectors to be protected from volatility, in fact this could provide you with additional hassles in that a portfolio that size would be near impossible for a retail investor to successfully manage.

You can successfully build a well diversified portfolio with as few a five ETFs, as long as you a.) keep an age-appropriate mix of index and bond funds and b.) add in “riskier” plays such as sector specific ETFs, or emerging market ETFs.

Lately, broad market sell-offs and rallies have made a diversified portfolio no more “safe” than an unbalanced portfolio, as market swings have occurred based on news concerning seemingly everything except the actual performance of a company or sector.

In this environment is is especially important to develop and stick to a long- term trading plan, invest for dividend yield, reinvest your dividends, as well as utilize dollar-cost averaging to manage risk and put yourself in a better position to realize profits.