Source: Sebastiaan ter Burg.
Savvy and novice investors alike had their eyes opened in August when the stock market dove by 10% for the first time in four years. While the stock market has historically moved higher over the long run, it also experiences periods of instability and volatility that can test the patience and long-term thesis of investors. And let's face it, not every investor has the mindset to withstand substantial volatility.
The good news is that investors seeking out more stable returns do have options when it comes to lowering their investment risk. Sure, they may give up the opportunity to find a stock that could gain 500% in a two-year period (which doesn't really happen all that often), but they'll likely gain the peace of mind to get a good night's rest, and give themselves a chance to generate considerably more stable returns.
For those of you who'd classify yourselves as "low-risk investors," here are three strategies to consider employing.
1. Seek out high-quality dividend stocks
Arguably the smartest strategy to reduce investment risk in the stock market is to seek out high-quality dividend payers. Buying names like Coca-Cola and Johnson & Johnson might sound boring on the surface, but dividend stocks can repay investors in a big way if they remain committed to their long-term holding strategy.
Source: Pictures of Money via Flickr.
Dividend stocks offer a number of advantages to risk-fearing investors that nondividend-paying stocks just can't offer. To begin with, dividend stocks demonstrate on a regular basis that they're profitable enough in the near-term, and have a strong enough growth outlook, to distribute a percentage of their profits to shareholders. A business with a questionable growth strategy is unlikely to continue to share profits. Thus, regular (and growing) dividend payments are usually a sign of financial strength.
Secondly, a dividend can act as a downside buffer when the stock market is volatile. Although a yield of 3% is unlikely to protect you from experiencing paper losses in your portfolio, a dividend payment alone is sometimes enough to attract long-term shareholders into a stock, which can help keep volatility down.
Finally, dividend payments afford you the ability to reinvest in the stocks you own, growing your stake and compounding the dividends you receive. Buying dividend stocks has worked for investing greats like Warren Buffett, and it can work for investors of all skill and income levels.
2. Build a portfolio around ETFs
Source: Flickr user Sara Hughes.
ETFs, or exchange-traded funds, come in a wide variety of shapes and sizes. There are geographic-specific ETFs that allow you to buy into the growth prospects of a country or region; sector-specific ETFs that give you the opportunity to invest broadly in businesses such as semiconductors or biotech; broad-market ETFs which closely track one of the major indexes; and of course growth- or income-specific ETFs that usually invest in dozens of stocks based on their investment strategy.
For management fees that are generally in the vicinity of 1% a year, risk-averse investors can fill their portfolio with as many diversified ETFs as they'd like. If they focus on income-based ETFs, low-risk ETFs, or index-based ETFs, they'll often give themselves an opportunity to reduce the volatility in their portfolios, or at worst, see them mimic what's being experienced by the broader market. This usually means no more worries about waking up one morning to find one stock that's down 20% is wreaking havoc on your portfolio. Given that equity ETFs are usually comprised of dozens of stocks, it's unlikely that a single poor performer will cause substantial downside.
3. Invest at regular intervals
Perhaps the easiest way to reduce your long-term investment risk is to keep adding money to your portfolio on a regularly scheduled basis, regardless of how well or poorly the market is performing. Studies have repeatedly demonstrated that it's impossible to correctly predict short-term movements in the market with any accuracy over a long period of time. If you're investing on a regular basis, you won't have to worry about whether you're catching the market bottoms because the history of a rising long-term market is on your side.
Source: Flickr user Kat R.
As an added bonus, investing on a regular schedule regardless of stock market performance helps keep your emotions out of your portfolio. While there's nothing wrong with selling a stock if the fundamentals have changed, you want to avoid selling based on temporary fears. Remember, high-quality stocks have a propensity to rise over the long run -- and if you can resist the urge to panic and divest during the inevitable short-term dips, you can be there to profit.
