How to reduce risk in your investments

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How to reduce risk in your investments

We know that when it comes to investing, one of the keys is to minimize errors. Success in investing is not so much about achieving high returns as it is about keeping risk under control and maintaining a cool head. This often involves moderating our impulses, whether they be euphoria or panic, and sticking to the long-term plan we had set for ourselves. In this article, we provide some tips to help you reduce risk in your investments.

A few years ago, journalist Jason Zweig studied brain behavior and applied the findings to the world of investments. The result was a book titled “Your Money and Your Brain“, which incorporates many conclusions from the work of psychologists Daniel Kahneman and Amos Tversky on the rational decision-making model. Regarding risks, Zweig proposes different strategies.

1. Sleep on it

Haste is almost never good. We now know that mood significantly influences how we perceive risks. Therefore, it is not advisable to make investment decisions after a bad day at work, after an argument with a neighbor, or in response to euphoria from past investment performance. The first piece of advice is simple: take your time and decide when you are calm.

2. Would you recommend it to your mother?

There is nothing like asking yourself this question to precisely gauge your confidence in an investment decision. Often, the key to avoiding unnecessary shocks lies in taking some distance. One of the most effective and accessible ways, Zweig suggests, is to ask yourself if you would feel comfortable recommending your investment decision to your mother. And if not, examine why.

3. Review history

We know that an axiom of investment is that past returns are not a reliable indicator of future returns. However, going back in time is necessary to vaccinate against claims of infallibility: booms always end with busts. Additionally, reviewing history is useful to check, for example, that low-interest rates do not have to last forever… or that unforeseen events cannot be ruled out.

4. Don’t confuse value and price

A classic stock market investment mistake is buying shares simply because they have been rising… and selling them because they have fallen. These decisions stem from confusion between the value of a company and the price of a stock. The reality is that if the value of a company’s business is solid, a drop in the stock price is an opportunity to buy more, not to sell. Furthermore, the lower the price, the lower the associated risk.

5. Develop a plan and stick to it

For most of us, it is advisable to invest with a long-term horizon—minimum of five years. Therefore, planning our investments well is essential: define what we want to achieve, how long it will take, and taking into account our risk tolerance. If the plan is solid, we shouldn’t deviate from it when, inevitably, markets fluctuate downward. Hold the helm and stay on course.

6. Think in probabilities

Perhaps if someone tells you about an investment with a 70% chance of success, it sounds very good. However, that means there is a 30% chance of failure. Are you comfortable with that risk? Zweig advises thinking like this: three out of every ten people investing in this will fail; will I be one of them? At the same time, investing 100 euros is not the same as 1,000 or 10,000. It is useful to think on a broader scale: in the context of my investments, what would the success or failure of this specific investment mean?

7. What if you’re wrong?

When it comes to investments, overconfidence can translate into a bad decision. So, a recommended strategy would be to assume that you could be wrong. When you are very convinced of your decision, search for well-founded critical opinions on the internet, examine them carefully, and revisit your decision. Does it still make sense, or is it better to discard it?

8. Know your limitations

We have already talked on the blog about risk tolerance. Zweig warns that our mood affects our perception of risk. Additionally, risk tolerance is often confused with “tolerance for making money.” That is, assumed risk seems perfectly acceptable when things are going well. Keep in mind that our brain experiences much more pain when losing money than pleasure when gaining it.

There are no certain paths to success in investments. In fact, we cannot control the success of our decisions, but we can reduce the risk of our investments. Therefore, it is advisable to have a plan, think carefully about the consequences if things go worse than expected, and protect against unforeseen events with diversification.

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