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The 10 best ways to reduce risk.

Article Excerpt
Many people were tempted to invest in the late 1990s by soaring equity valuations - especially among technology companies - only to be hammered when the bubble burst between 2000 and 2003. Losses on shares, funds and pensions woke novices up to the risks involved in investing in equities. And for lots of them, the risks still appear to be too high, so they have now turned their backs on the markets altogether.

However, investing does not have to be as risky as some now believe it is. Indeed, sensible investors can protect themselves against risk while profiting from all market conditions. There are lots of ways in which you could protect your portfolio from, or speculate on, falling markets, depending on your attitude to risk and your level of sophistication. So even if stock markets are flat or falling, you can ensure your portfolio keeps on growing.

Before we explore our 10 strategies, there is one strategy that we should all learn by rote and that is: the key lesson is to abandon any obsession with the performance of your holdings relative to the FTSE 100 index, and to focus instead on making absolute returns. There's no point in outperforming an equity index if both it and you lose money - the real goal of investing is to outperform cash (and inflation).

This absolute-returns approach opens up two strategies: diversification and hedging.

Diversification means spreading risk across a range of asset classes, not just equities, because some holdings should perform well when equities are out of favour. Investing in equities alone is taking on a lot of risk, as the world's stock markets are increasingly closely correlated (which means they move up and down together).

For instance, US equities are 83 per cent correlated with the FTSE All-Share index, while European equities are 80 per cent correlated. By contrast, gilts (bonds issued by the UK government) have a -1 per cent correlation and direct commercial property has a -8 per cent correlation with the FTSE All-Share (source: www.bestinvest.co.uk).

Of course, these correlations are based on overall indices and it may possible to find shares within an index that have negative correlations with the main market and could act as defensive hedges for your portfolio in a falling market. But, that said, it is very hard to find suitable equities as hedges, especially because historical correlations may not be repeated. For instance, just one share in the FTSE 350, Rangold Resources, has had a negative correlation with the index over the past five years.

Of course, investing in asset classes other than equities is likely to reduce your overall returns in the long term, as equities have outperformed historically (provided you reinvested the dividends). Nevertheless, equities' historical outperformance may not be repeated.

One way to smooth out the effects of market volatility to some extent is to make regular savings. Investing a lump sum involves timing the market, which is...