Investing is a risky business but you can make it a lot safer by following some simple guidelines.
Risk and reward are joined at the hip. On the whole, you need to take greater risks to reap stronger gains, so don't let anyone tell you that you can make easy money with little or no downside.
Indeed, if you do find something that seems both high return and low risk, that probably means you've massively underestimating the risks you are taking on. Just ask any banker who used to trade bundles of sub-prime mortgages.
But there are some simple guidelines you can follow to minimise the risks you face when investing. Here are three of them:
Margin of safety
One of the easiest ways to limit the risk of making losses is to never overpay for a company, no matter how exciting it sounds. This is what has made investors like Benjamin Graham and Warren Buffett so successful.
For example, if you think a share is worth 400p, then only buy it if it's trading at 300p or less. This concept is called 'margin of safety'. It will certainly make you a more discerning investor, and that's no bad thing.
Any estimates you make when valuing a company are liable to error, so giving yourself some leeway means you can afford to be a little out in your calculations and still end up in the black. The riskier the investment, the bigger the discount you should demand before making any purchase.
It's not foolproof of course. You might have grossly overestimated what the share is worth!
Have lots of eggs
Diversification is a fantastic way to reduce risk and it'll probably boost your returns, too.
Putting all your money in one company is extremely risky. One unexpected mishap, an accounting fraud for example, could wipe you out. Spreading your cash over a number of companies in the same sector is not much better, as they will tend to rise and fall at the same time.
So it's best invest in a number of companies and a variety of sectors. Opinions vary over how many companies you need to get decent diversification. Some studies suggest as little as 10 to 12 well-chosen shares could be sufficient.
You can go even further and invest in non-UK companies and funds. Again, how much extra diversification this gives is subject to debate as many major stock markets seem to move in unison these days. Then you can diversify between asset classes as well, adding in some bonds, commodities and so on.
Shuffle your eggs
Diversification aside, I'm all for making bigger bets on companies that you think are particularly robust and deeply under-valued. But, as you hold a share and (hopefully) the price rises, your risk is going up too. It's a larger part of your portfolio and likely to be less undervalued than it was when you first bought it.
The same principle applies when you're diversified between different assets as well. This is when a little rebalancing can work wonders. You sell some of the best performers, that are now looking perhaps a little bit toppy, and reinvest the cash in the investments you think look the most undervalued.
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