Financial risk is any uncertainty with respect to your investments that has the potential to negatively impact your financial welfare. It generally relates to the odds of losing money. Of course, there is no avoiding risk in every aspect of your life, and the same is true of your finances. When you invest, you make choices about what to do with your financial assets.

All investments carry some degree of risk. Most investments, like stocks, bonds and mutual funds, for example, lose their value when market conditions are poor. Even conservative investments, like certificates of deposit, carry some risk. With certificates of deposit, for example, you are exposed to inflation risk, which is the risk that your investment doesn’t earn enough over time to keep pace with inflation.

Financial risks are everywhere and affect nearly everyone. The good news, however, is that by being aware of them and knowing how to protect yourself, you can help to mitigate your risks and reduce the chances of a negative outcome. In today’s article, we will discuss some basic strategies to help you to be better prepared for and mitigate risk.

Diversify

When it comes to investing, you've probably heard that you should diversify your portfolio and never put all your eggs in one basket. But how can you broaden your horizons? What are the most important requirements? What exactly does diversification mean? Diversification is a risk-reduction strategy that spreads investments over various financial instruments, sectors, and other categories. Its goal is to maximize profits by investing in multiple industries, asset classes or countries, for example, that react differently to the same occurrence. Although diversifying does not guarantee a loss, most investing professionals believe it is the most crucial component of achieving long-term financial goals while limiting risk.

Diversification can aid in risk management and decrease the volatility of an asset's price changes. However, keep in mind that risk can never be avoided, no matter how well-diversified your portfolio may be. You may lower the risk associated with specific equities, but overall, market hazards influence practically every stock, so diversification across asset classes is crucial. You should also diversify by sector and geographically. If you are new to investing, consider investing in mutual funds where professional money managers' main focus is to ensure they are picking the right equities and efficiently diversifying across all the major characteristics mentioned.  The idea is to strike a balance between risk and reward. This way, you'll be able to meet your financial objectives while still enjoying a decent night's sleep.

Rupee-Cost Averaging

First coined by Benjamin Graham in his book The Intelligent Investor, dollar-cost averaging, known as rupee-cost averaging in India, is a simple investment strategy that entails investing a fixed amount of money in the same investment, such as a mutual fund or equity, on a regular basis over time. With this strategy, you don't have to worry about trying to buy low and sell high. After all, we all know how difficult trying to time the market is. Instead, you ignore the price fluctuations of your investment and put the same amount in no matter what.

Essentially, you buy more shares when the investment price is down and fewer shares when the price is up. The averaging term refers to the fact that, over time, you reduce your average cost per share. On the other hand, if you put your money into the market all at once, you might end up buying at the peak. Ultimately, rupee-cost averaging helps you decrease the amount you pay while minimizing risk. Other benefits include the enhanced ability to ride out market downturns, prevent bad timing and enable more disciplined savings.

Asset Allocation

Every well-constructed portfolio starts with an asset allocation that is personalized for you. Your asset allocation is the optimal mix of asset classes, like equities, fixed income and cash, for example, and is based on a variety of factors, including your goals, the time horizon to achieve those goals, tolerance for risk, age, and more. Your asset allocation maximizes your opportunity to achieve your long-term goals. Determining your asset allocation is not simply a one-time process. Indeed, it is imperative that you review your asset allocation on a regular basis to ensure that it is still aligned with your investment goals and risk tolerance.

A common confusion among those new to investing is the difference between diversification and asset allocation. Asset allocation refers to the percentage of stocks, bonds, and cash in your portfolio (including other alternative asset classes including real estate, commodities, etc.). Diversification, however, refers to the spread of the money within each asset class. With asset allocation, you typically determine your personal target asset allocations based on factors such as your risk tolerance, time horizon, and investment objectives.

As an example, assume your objective is to build out your retirement nest egg and you have 25 years until you retire. This obviously means you have time on your side to take on additional risk in your portfolio to possibly achieve greater growth. As you approach retirement, however, your tolerance for risk will not be as high, and your asset allocation will need to be adjusted accordingly.

Rebalancing

One other important element of achieving your portfolio goals while minimizing risk is that you rebalance your asset allocation on a regular basis. Did you know that your portfolio’s risk level can change even if you didn’t change any of your investments?

Over time, market fluctuations can change the value of your investments and, ultimately, your asset allocation weightings, so you are no longer tracking to your original plan. Indeed, your portfolio risk may inadvertently increase if your asset allocation is no longer aligned to your goals and risk tolerance. Therefore, it is important to rebalance your investment portfolios on a regular basis, which is the process of changing the weightings of the assets in your portfolios.

It means that you buy and sell positions in your portfolio to get back to your original asset allocation. The main benefit of rebalancing is that it maintains your desired risk level over time. Rebalancing also allows you to implement any changes you make to your investing style or asset allocation, as is sometimes necessary over time. To rebalance your portfolio, you can either invest additional funds in any asset class that is underweight or sell investments from an asset class that is overweight and then, invest those funds in an asset class that is underweight.

A key consideration when selling investments in your portfolio, however, is tax implications, so ensure that you take tax implications into consideration when determining the optimal way to readjust your portfolio. One of the other disadvantages of selling one asset class to reinvest in another is that you are required to sell your highest-performing assets. If you rebalance by contributing new funds, you can hopefully leave your winners to continue to outperform.

Benefit from the Power of Compounding

One important but rather complex-sounding concept of investing is the power of compounding. Don't worry – it's honestly not as scary as it sounds! As you know, the money you save earns interest, whether it is in savings, equities or mutual funds. When you save, you earn interest on the money you originally saved plus on the interest you've accumulated. You might be wondering why compound interest is so important. It's important because it enables your wealth to grow faster.

In fact, according to Albert Einstein, "compound interest is the eighth wonder of the world. He who understands it, earns it..... he who doesn't....pays it". One of the key success factors of benefiting from compounding is that time matters, and you need to be invested for the longer term. So not only do you benefit from the power of compounding, but you also help reduce your risk by staying invested through multiple market cycles.

If you aren’t comfortable with assuming a lot of risk, investing early and giving your money time to grow will help you better manage your financial risk while staying true to your personal risk profile. By ensuring you consistently practice financial risk management basics, in addition to sticking to your budget, building and updating your financial plan, and diversifying and rebalancing, among others, you will be in a better position to persevere through market volatility and meet your financial goals.

After all, you can’t eliminate financial risk, but you can mitigate the harm and reduce the chances of a negative outcome. If you want to keep your hard-earned money safer and keep your investment losses to a minimum, understanding these financial risk management basics is key.

An Investor Education and Awareness Initiative of Aditya Birla Sun Life Mutual Fund. All investors have to go through a one-time KYC (Know Your Customer) process. Investors to invest only with SEBI registered Mutual Funds. For further information on KYC, list of SEBI registered Mutual Funds and redressal of complaints including details about SEBI SCORES portal, visit link: bit.ly/Birla KYC for further details. Mutual Fund investments are subject to market risks, read all scheme related documents carefully