3 tips to help you reduce downside risk in your investment portfolio

While most investors are focused on the potential for gains – particularly in a bull market – it’s imperative that you consider worst-case scenarios. By accounting for downside protection in your portfolio, you can avoid losing the proverbial shirt off your back. 

What is Downside Protection?

Any investor – whether you have millions of dollars in your portfolio or just a few thousand – needs to understand and appreciate the importance of downside protection as part of an investment strategy.

As Investopedia’s James Chen explains, “Downside protection on an investment occurs when the investor or fund manager uses techniques to prevent a decrease in the value of the investment. It is a common objective of investors and fund managers to avoid losses and many instruments can be used to achieve this objective.”

While there’s no foolproof strategy for totally insulating your investments against risk, there are plenty of strategies you can layer together to create more cushion. 

3 Ways to Reduce Downside Risk

As you look to protect your downside and maximize your potential for earnings, here are a few techniques to consider:

1. Surround Yourself With Multiple Voices

You never want to depend on a single voice for your investing advice. It doesn’t matter if his name is Warren Buffet – you need multiple voices. Every investor or advisor has their shortcomings and mistakes. By listening to a handful of people and sources, you create a sounding board for ideas. 

When you’re just starting out with investing, consider subscribing to multiple online resources. Sophisticated Investor is one great option. (They have a variety of resources, including articles and a newsletter.) If you’re interested in real estate, BiggerPockets is another good choice.

As you build more wealth, you’ll benefit from working with not one but two financial advisors. By putting half of your funds with one and the other half with another, you add more downside protection to your portfolio.

2. Use Dollar-Cost Averaging

There are two schools of thought with investing. The first group believes you should try to time the market and invest your entire lump sum of available money when you feel it’s right to do so. The second group says it’s better to invest a little bit of money each month at the same time. This latter concept is known as dollar-cost averaging.

While it’s not a perfect strategy, dollar-cost averaging has proven to be a much more effective method of investing when viewed through the lens of 10, 20, or 30-plus years. It allows you to spread your money out across both low and high market points. And when you average it all out, this approach tends to generate a better return. 

3. Diversify Your Investments

Diversification is one of the core tenets of smart investing and proper downside risk protection. Here are a few tips you can use to diversify your investments and prevent a situation where too much of your wealth is tied up in a single place:

- Market cap diversification. The first type of diversification refers to buying funds that include different types of companies. In other words, you should invest your 401k/IRA into a variety of large-cap, small-cap, and growth funds. This spreads out risk and exposes you to a variety of market types. 

- Regional diversification. While the majority of your wealth may be invested here in the United States, there’s something to be said for putting a percentage of your investments into international funds and other forms of regional diversification. 

- Asset class diversification. For optimal diversification, you should invest in a variety of asset classes. This includes stocks, bonds, precious metals, cryptocurrency, real estate, etc.

The more you diversify, horizontally and vertically, the less likely it is that one negative factor will deplete your wealth. If you follow nothing else from this article, be sure to prioritize diversification.

4. Think in Terms of Buckets

“The Bucket System” is one of the more popular investment strategies. And at its core, it’s predicated on the idea of diversification. 

With the Bucket System, you view your investments as falling into three different buckets labeled now, soon, and later. The now bucket is money that you need right away. This consists of emergency funds, cash, and other liquid investments. The soon bucket deals with money that you’ll need with a few years. This is where you stash things like CDs and mutual funds. The later bucket refers to retirement. This is where your 401k/IRA, annuities, and other long-term products go. 

Be a Smarter Investor

Smart investors don’t take massive, misguided risks. And while they aren’t always ultra-conservative either, they tend to make wise decisions that are supported by adequate downside risk protection. 

If you want to generate better returns over the long run, you’d be wise to do the same.