Here's what Warren Buffett says is 'the best way to reduce risk' (not buying the S&P 500)

Diversifying into different asset classes can be a strategy for trying to manage risk in a portfolio. But this is not what billionaire investor Warren Buffett thinks investors should do.

According to the big man's investment vehicle, Berkshire Hathaway it currently holds about 25% of its total assets in cash and cash equivalents. Buffett's advice to shareholders is quite different.

Buffett's advice

At one annual meeting, Buffett offered the following advice to Berkshire shareholders on how to manage risk:

We think the best way to reduce risk is to 'think'… have your default position as short-term instruments and whenever you see anything smart to do, you should do it.

The idea is straightforward. Instead of trying to balance stocks and bonds, investors should keep their money in something they can easily access until they see a long-term opportunity.

Opportunities to buy shares in outstanding businesses at attractive prices rarely arise. That's why it's important to be ready to take full advantage of them when they appear.

Thinking

According to Buffett, the key to reducing risk is thinking. That means identifying businesses with good future prospects and figuring out what their fair value might be.

I think InterContinental Hotels Group's (LSE:IHG) is a good example. The company has 6,430 hotels in its network, with another 2,225 on the way.

The flexibility of its properties means that IHG has relatively low maintenance costs. As a result, 90% of the money generated by the company can be invested for growth or used for dividends and share buybacks.

The company is also protected by the high cost of switching operators. Once the hotels are part of their network, switching to another franchise becomes difficult and expensive.

Measurement

There is much about IHG that is attractive from an investment perspective. But there are also risks to consider in determining how much they should be willing to pay for a stock.

One of these is the height of Airbnbwhich continued to increase. That is a strong competitor that will make it very difficult for IHG to continue to increase its market share in the future.

Currently, IHG shares trade at about 25 times free cash flow. That's high, but given the firm's attractive economics and growth prospects, I don't think it's entirely unreasonable.

To try and reduce the risk in my portfolio, I would look for a better margin of safety before buying. That may come from an improved idea, or it may come at a lower price.

Risk management

According to Buffett, the way to reduce risk is not to keep a fixed allocation in different asset classes. It's about thinking carefully about businesses and what they're worth.

Good investing involves buying stocks when they are trading at attractive prices. And figuring this out involves understanding what the company's long-term prospects are.

This is not always the case for all businesses. But that's okay – as Buffett says, investors only need to find a few good opportunities to outperform over time.