How to manage investment risk

What is risk management in finance? 

Investment risk refers to the possibility of making a loss when investing. Risk sits on a scale, as all investments involve some risk. The level of risk can be nearly zero, but there will always be some risk attached and it’s your responsibility to balance risk and reward.

It’s important to take the time to fully understand investment risk before committing, though risk management strategies can be applied to mitigate it within your portfolio.

Principles of risk management

The fundamentals of investment risk management start with determining how risky an investment is, then deciding what action to take based on that information.

Risk can be quantified. This can be a complicated process, but there are some basic concepts that don’t require high-expertise — such as assessing historical data or company credit scores.

You’re probably already familiar with some of the processes of managing investment or financial risk. For example, banks will run a credit check on you before approving credit or a loan. If you already invest, you may opt for a diverse portfolio of shares, funds and other assets across different sectors, or you might pause your monthly trades to replenish your rainy day savings after needing to use some to repair your car. These are all ways that investors will help manage the potential impacts of risk.

Along every step of risk management, you need to understand your own risk tolerance and determine what you’re personally willing to lose. No one can fully decide this for you, as it’s personal to your finances and goals.

Five risk management techniques 

You don’t need to become a professional risk manager to keep on top of your risk level. Nearly everyone can take these five essential and well-known risk management techniques and apply them to the financial and investment world. They can also be applied to other scenarios which involve risk.  

How to reduce investment risk 

While there is no way to entirely eliminate risk, there are several strategies to help reduce risk levels when investing. Though there are plenty more tactics out there, here are five strategies you can take into investment planning and management:

1. Asset allocation 

Asset allocation refers to how your portfolio is broken down into investment types and classes. How your portfolio is structured will depend on your tolerance to risk. If you have a higher risk tolerance, your portfolio might consist of 80% equities and 20% bonds. But if you’re a more conservative investor, your portfolio could be the reverse and consist of mostly low-risk investments.

You can fine-tune your portfolio over time to make sure it suits your needs, goals, and appetite for risk.

2. Diversification 

A balanced portfolio might include a range of risks, but this doesn’t necessarily mean you have a diverse portfolio. To achieve diversification, not only do you need a range of risk levels, but also diverse holdings in your portfolio.

If you only invest in one company, you open yourself up to ‘single-security risk’, which means your investment relies on the price of one single holding. Similarly, focusing investments in just one sector means your assets may all be affected by the same external factors.

However, if you invest across various sectors and companies, it’s less likely that you’ll lose your entire investment as some of them will grow to offset any potential losses. Bear in mind, this isn’t guaranteed and you should still be prepared to lose everything you put in.

3. Pound-cost averaging 

Much like a consistent direct debit to a subscription service, pound-cost averaging involves drip-feeding a fixed amount of money into the market on a regular basis — regardless of the market performance.

Rather than investing a lump sum of money in one go, you spread the costs. For example, you could buy £12k units of a specific stock on one occasion and risk overpaying the value, or you could invest £1k into that same stock over twelve months and potentially buy units at a lower cost at some point due to market fluctuations.

Most investment platforms offer drip-feeding, such as our free regular investing service -  which allows you to set up a monthly direct debit to invest little and often.

4. Monitoring your portfolio 

You have the ultimate say over your portfolio. Make sure you keep an eye on your investment performance, scheduling in regular check-ins. If you feel uncomfortable or unsure about the level of risk you’re currently taking, you can take action to reshuffle your portfolio. This could involve withdrawing your money from a risky investment and reinvesting in a safer option.

5. Let someone else handle the risk for you 

Balancing and rebalancing your investments to manage risk can be time-consuming. There are plenty of options which allow you to give up some of the control, such as mutual funds, ETFs, or managed accounts.

The ii Managed ISA offers you the choice of five different risk profiles to match your appetite, ranging from cautious and conservative to aggressive and adventurous.