Investors in stocks must willingly accept this reality: There’s no reward without risk. Bigger risk leads to bigger rewards. But how do you deal with these risks.
Those that made investments amid the ongoing Crimea crisis in Ukraine, for example, took a big risk, but if their strategies are sound, the potential rewards are also huge. Taking risk is part of the equation to building wealth in almost every case (unless you have some inside information- which is illegal). The key to success is how you handle risks.
Let’s examine four major types of investment risks and what strategies you could adopt to help you manage them.
1. General market risk. The economy goes up and down. Everyone in the markets is susceptible to this systemic risk – the potential that market shocks, be they a geopolitical crisis, an act of terrorism, a recession or a natural disaster, rile market sectors. On top of those, government policy issues, such as the debt ceiling fight, tax hikes and sequester cuts and, of course, the global contraction of credit, all add to market uncertainties. We don’t see any of these this year yet, but an investor must always have a good strategy in place in case one or more of these events occur.
Tactic: Try the core and satellite approach. This is a method of portfolio allocation that most institutional and savvy investors use. You keep passively managed investments at the core of a portfolio, and make actively managed ones the satellites seeking greater returns in different market climates under a skilled money manager’s guidance.
Use alternative investments, such as private equity and commodities, as the satellite component, and typical stocks and bonds as the core. Have an active manager who charges low fees and has consistent outperformance to look after your core.
For individual stocks that log significant gains, consider adopting a strategy called collaring – that is, writing a call option and purchasing a put option on equivalent shares. This risk management method trades profits for protection. Buying a put protects you from a stock falling below a set level, known as a strike price, which allows you to unload the shares before they sink lower. Selling a call (permitting the buyer to acquire the stock at a strike price) gives you a premium that helps lower the put’s cost.
This way, you have a covered call, a protective put and two exit prices for the stock that hedge your positions to limit risk. Collaring is highly useful when volatility strikes Wall Street and markets turn bearish.
2. Credit quality, interest rate and inflation risk. When investing in the bond market, you encounter these three risks. A rating agency such as Moody’s, Standard & Poor’s and Fitch Ratings assess a bond issuer’s ability to repay debt. They may downgrade a corporate bond’s credit quality, implying a greater default risk. Bond prices fall when interest rates climb – if the Federal Reserve (mercifully) ends all of its emergency measures, quantitative easing and zero percent short term rates. Rising inflation rates can turn a bond that seemed like a can’t-miss investment years ago into the biggest loser at maturity when you get your money back.
Tactic: Build a diverse mix of bonds and bond-like investments. Be very cognizant of how long it takes for your bond to mature. Buy bonds in a laddered strategy where the maturity dates are staggered, or target date funds which automatically diversify based on your risk tolerance. Consider zero-coupon or revenue bonds, or explore hybrids like preferred securities or structured notes.
3. Diversification and concentration risk. Simply said, it occurs when a portfolio isn’t varied enough. However, variation means not only to having different types of stocks or bonds, but also investing in different sectors of the economy.
Some investors concentrate everything in a handful of stocks or a couple of funds representing just one or two hot market sectors. If macroeconomic problems hit those companies or industries, that undiversified portfolio may suffer a major setback. The flavor of the month can sour next month. Even a bad earnings season may do significant damage.
Tactic: Develop an allocation formula that keeps you diversified across multiple asset classes and investment styles, including in assets that are not stocks or bonds. Avoid redundant holdings between investments, or concentration on a handful of popular sector bets. Always keep some cash in hand.
4. Re-investment and timing risk. Many people leap in and out of the market with short-term upswings and dips. Trying and failing to time the market, they end up reducing the long-term performance of their portfolios. A research report by Standard & Poor’s shows that, if an investor has $10,000 in an index fund mimicking the S&P 500 on Jan. 1, 1994, he or she winds up with $58,350 at the end of 2013. But if the same investor misses just five of the top-performing days during those 20 years, the person only amasses $38,723.
Besides, bond investors commonly face re-investment risk. When a bond matures, there’s no guarantee that you will find the same interest rate on your new investment.
Tactic: Instead of jockeying in and out of stocks and funds, buy and hold while scheduling consistent income through bond laddering. Use dollar cost averaging strategy to pick up more shares of quality companies with a fixed amount of money invested at scheduled intervals. Employ tax loss harvesting – a technique to reduce your Internal Revenue Service bill by selling securities at a loss and deducting that from your taxable income.
Life and investing are filled with risks; losses at times are unavoidable. So have a plan of action with ample strategies to systematically respond to risks and adapt your portfolio as needed.