SIE Ready⚠️ Investment Risks · Lesson 5 of 5 · 5 min
Managing Risk: Allocate, Diversify, Rebalance, Hedge
⚖️ No tool removes risk. Each one trades a specific risk away, usually for a cost or a smaller upside.
💡 Key idea
Allocation sets the mix, diversification spreads within it, rebalancing restores it, hedging insures a specific position at a cost.
🧠 Why it matters
ASSET ALLOCATION divides a portfolio among categories such as stocks, bonds and cash, based on the investor's TIME HORIZON and RISK TOLERANCE (ability and willingness to accept losses for potentially higher returns). A longer horizon generally allows more volatile holdings because there is more time to recover. DIVERSIFICATION spreads money among many investments, both between and within categories, to reduce company-specific risk; it does not guarantee a profit or prevent loss. REBALANCING brings a drifted portfolio back to its target mix by selling overweight categories, buying underweight ones or directing new contributions; it can create costs or taxes. HEDGING offsets a specific risk, for example buying a put to protect a stock position, at a cost that lowers returns.
📈 In the real world
🧭 Sam, 28, saving for retirement, and Ruth, 70, needing income next year, ask the same firm about risk. Sam's long horizon lets his allocation lean on stocks; Ruth's short horizon and low risk tolerance point toward steadier holdings. A year later, a stock rally has pushed Sam's mix from 80% to 88% stocks, so he rebalances back to 80%.
📌 Takeaways
- Time horizon and risk tolerance drive asset allocation
- Diversify between and within asset classes; it reduces but never removes risk
- Rebalancing restores the target mix; hedging protects a position at a cost
📖 Terms in this lesson
Diversification: Spreading money across many securities so one holding's problems hurt less; it reduces unsystematic risk only.
Asset allocation: Dividing a portfolio among asset classes such as stocks, bonds and cash to match goals and risk tolerance.
Rebalancing: Buying and selling to bring a portfolio back to its target allocation after market moves.
✅ Test yourself
A portfolio's target is 60% stocks and 40% bonds. After a stock rally it is 70/30. Which action is rebalancing?
- Buying more stocks to ride the trend
- Selling bonds to raise cash for stocks
- Moving everything into cash until prices fall
- Selling some stocks and buying bonds to restore 60/40
Answer: D · Selling some stocks and buying bonds to restore 60/40
Rebalancing returns the portfolio to its target mix: trim the overweight category (stocks) and add to the underweight one (bonds). The other actions move further from the target or abandon it.
Which factor generally allows an investor to hold more volatile investments?
- A low tolerance for losses
- A goal of preserving principal
- A long time horizon
- A need for cash within a year
Answer: C · A long time horizon
A longer horizon gives more time to recover from downturns, so more volatility can be tolerated. Near-term cash needs, low risk tolerance and a principal-preservation goal all point to steadier holdings.
An investor who owns a stock buys a put option on it to limit potential losses. This strategy is called:
- Diversification
- Asset allocation
- Hedging
- Rebalancing
Answer: C · Hedging
Buying a put to offset losses on a specific position is hedging; the put's cost reduces the return. Rebalancing restores a target mix, diversification spreads money across holdings, and asset allocation sets the mix of categories.
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