Chris Smith from CMC Markets explores the psychology and practice of managing risk in your portfolio.
Risk is often framed in technical terms – volatility, asset classes, macroeconomic forces. But at its core, risk management in investment begins with the investor themselves.
How well you know yourself, and your risk appetite, will determine your investment behaviour. Some people are born risk averse, some people are drawn to risk – there is no right or wrong.
While markets are driven by data, performance, and global events, outcomes for individual investors are just as heavily influenced by behaviour, discipline, and emotional intelligence. Understanding risk is not just about markets – it’s also about understanding yourself.
The human factor
Investors are not exempt from human emotions – fear, greed, impatience. And these emotions often dictate decisions about investment.
This behavioural dimension of risk may be underestimated. The ease of modern trading is a game-changer in many ways, enabling trading at the tap of a screen. But for some investors who are prone to knee-jerk reactions, this can enable impulsive behaviour.
If there is a unifying principle in effective risk management, it is preparation. Markets are inherently unpredictable, but investor responses do not have to be.
Here’s an analogy: some daring types may choose to do backflips on motorbikes, but not consider it risky because they have done so much training. The same logic applies to investing. What appears risky to one investor may be entirely manageable to another – if they have the right knowledge and experience.
If you jump into high-risk shares without understanding the market, you are far more likely to fail.
Preparation, in this sense, needs to go beyond basic financial literacy. It involves actively engaging with investments: reading annual reports, tracking performance, and staying alert to changing conditions.
Aligning risk with objectives
Risk tolerance is not static – it evolves over time and should align with an investor’s goals.
Take KiwiSaver, for example. It makes sense to invest in higher-risk funds when you are younger, as you have a longer time horizon to absorb fluctuations due to market volatility and maximise long-term growth potential. But as you approach retirement age you may want to become more conservative to reduce exposure to sudden market declines.
This approach reflects a broader principle: the purpose of an investment should dictate its risk profile. Growth-focused portfolios can tolerate higher volatility, while income or capital-preservation strategies demand stability.
You need to understand your aim for investment. Do you want retirement security, or are you financially able to withstand high risk for quick gains? If you understand your aim, you will be able to ride out times of uncertainty more effectively.
Without this clarity, investors risk adopting mismatched strategies – chasing high returns with low tolerance for losses, or settling for conservative assets that fail to meet long-term goals.
Strategies for managing risk
While psychology plays a role in assessing risk appetite, investment strategies are essential for managing risk.
Diversification is one of the most widely accepted tools. By spreading investments across asset classes, sectors, and geographies, investors reduce the impact of any single underperforming asset.
However, diversification is not without debate. Some of the richest people in the world have put all their money into stock picking and limited businesses. Again, it’s all about your end goal and risk appetite.
Diversification mitigates risk – but concentration can amplify returns for those with the expertise to pursue it.
Asset allocation is equally important. Adjusting the balance between equities, bonds, and cash allows investors to tailor risk exposure to their tolerance and objectives. Regular portfolio review ensures that allocations remain aligned over time. Market movements can shift weightings, inadvertently increasing risk if left unchecked.
Another approach, which is favoured by some financial advisers, is dollar-cost averaging. By investing fixed amounts at regular intervals, investors smooth out market volatility and reduce the risk of poor timing.
Hedging, through instruments like options or futures, can provide protection against downside risk, though it typically requires more sophisticated knowledge.
And liquidity management is often overlooked but critical. It’s important to understand liquidity risk. Property syndicates, for example, are hard to get out of, and there needs to be a regular risk premium payment to make up for this.
Finally, maintaining an emergency fund ensures that investors are not forced to liquidate long-term investments during downturns.
Lessons from experience
Experience remains one of the most effective teachers of risk. About 20 years ago, I invested in hot IPOs that pumped and dumped. I didn’t invest too much money, so the losses weren’t significant, but it provided me with some great lessons.
There can be value in learning through controlled exposure – taking risks, but within limits that allow for recovery.
Today’s investors face an additional challenge: the influence of social media. Trending sectors – whether cannabis, artificial intelligence, or electric vehicles – can generate intense interest and inflate valuations.
Listen to the chatter, but temper your expectations and don’t be tempted to heavily invest based on hype.
Activity in volatility
While volatile geopolitical environments can give investors cause to pause, some thrive on such risk.
CMC Markets clients (who use contract for difference (CFD) to speculate on asset price movements) often increase their activity during volatility, viewing it as an opportunity. These traders are experienced and engaged – therefore able to effectively read the data and make informed decisions.
Risk is subjective. What matters is not whether volatility exists, but whether the investor is equipped to navigate it.
It requires a combination of self-awareness, education, strategic planning, and ongoing discipline. Investors who master these elements are better positioned to withstand market fluctuations and achieve their long-term objectives.
*Disclaimer: The information in this article is of a general nature and not intended to be personalised financial advice.
