Portfolio Risk Management Strategies

Your personal investment portfolio is unique to you. From those ten Amazon shares you bought in your twenties to that ETF you bought last year, and that Dogecoin you initially bought as a joke. But no matter what’s in your portfolio, we all face the same types of risks. Now, not all of us are fund managers or accountants, so here is a guide to better managing your risks and building a diversified investment portfolio. 

Know Thyself - Portfolio Risk Analysis

Love it or hate it, risk is unavoidable. But of course, the good news is that there’s a trade-off between risk and return. The higher the risk, the higher the return. 

So the first step is to ask yourself, where on the risk-return frontier do you want to be? What is your risk tolerance? Everyone wants higher returns, but what level of portfolio risk will keep you up at night? Money can’t buy you sleep.

If you are unsure of your attitude towards risk, try an online questionnaire. Are you conservative, average, or a risk-taker?

So you are a risk-taker? A base jumper and a swimmer with sharks. Or maybe you just want returns that are a little higher than a term deposit. But no matter your attitude towards portfolio risk, you have to also know how much money you can afford to lose before it starts to have serious negative consequences on your life. This is your risk capacity. A low-risk investment that fails and ends in the bank repossessing your house is worse than a high-risk investment that fails and only costs you your annual holiday. 

It is also important to keep re-evaluating your attitude towards portfolio risk over time. You may be ok to jump in the water with sharks when you are twenty-something, but at 45 years old with kids, you may prefer to go to Sea World.

Nearing retirement is a key time. It is wise to take a more conservative approach. Safeguard those years of returns just in case there is a surprise recession or market crash around the corner.

Invest Across Different Types of Assets

We all know not to put all our money in one stock. But it is just as crazy to put all your money in one asset class. 

You may have a beautifully diversified stock portfolio, but that will not help you if the entire market crashes. However, if you also hold some gold, cash, bonds, Bitcoin, or security tokens, your losses may not only be smaller, but you could also end up making more money over the long run.

The key is to allocate your money across asset classes whose returns don’t move in the same direction when faced with the same events. Traditionally, stocks and bonds have had an inverse relationship, although that is less true these days. Gold, property, and in theory Bitcoin perform well when the value of stocks fall or inflation takes off. And if everything goes to hell in an egg basket, then hopefully good old cash will be ok. 

SECURITY TOKENS ARE WORTH CONSIDERING 

Security tokens are a brand-new and innovative asset class that allows you to purchase equity or debt in various types of ventures, presenting an opportunity to purchase assets that may move differently from other assets.

WHAT IS A SECURITY TOKEN OFFERING (STO)?

A security token on a blockchain can be compared to a stock in the stock market. Security tokens and their offerings (STOs) are subject to regulations in the jurisdictions where they are available to purchase. They combine the technological benefits of a blockchain to securitize the underlying assets.

What percentage of your portfolio you allocate to each of the different asset classes will depend on your risk tolerance and capacity, as some asset classes are riskier than others. Cash is king for conservative investors, while junk bonds are great for those base jumpers. And for the super-wealthy squeamish about cash, there are government bonds with negative interest rates! 

Cash also has the benefit of being the most liquid of assets, which allows you to invest quickly in other assets as opportunities emerge.

It is also important to have a strategy for maintaining and rebalancing your allocations. As the value of your investments change, your percentage exposure to each asset class changes. Consider rebalancing your portfolio as assets change in value.  

DIVERSIFY YOUR STOCK PORTFOLIO WITH ALTERNATIVE INVESTMENTS

It turns out that spreading your money across different stocks is also a good idea. Without going into all the academic details, owning five stocks is less risky than owning one. Ideally, you want to hold a small selection of stocks; this will eliminate most of the idiosyncratic risk (also called unsystematic risk) coming from the individual stocks. You will then be left with the general market risk (also called systemic risk). It pays to have portfolio risk management strategies.

WHY INVEST IN ALTERNATIVE ASSETS?

We’ve heard it before; diversify your assets to reduce your portfolio risk. But why does diversifying your portfolio reduce risk? In simple terms, it’s because different asset classes react differently in different economic environments. While an event may cause stocks to go down in price, it may cause bonds to go up in price. Therefore, buying a selection of different asset classes may add stability to your portfolio at large. 

If picking stocks sounds daunting, try an ETF (Exchange Traded Fund). An ETF buys a range of stocks in a market or industry, yet all you have to do is buy a piece of the ETF. The price of the ETF moves with the changing value of the underlying stocks. Of course, you surrender a degree of control compared to constructing your own portfolio.

Choose Your Level of Alpha and Beta

After committing to diversifying your stock portfolio, you also need to ask yourself how you want your portfolio to perform relative to your country’s main stock index, such as the S&P 500 in the US. 

Consider the index as a benchmark for your returns and risk. If you build a portfolio that reflects the stock index, your returns and risk should mirror the index. Many fund managers have their performance marked against their local index.

But if you want to take on more risk for a chance of outperforming the index, you can build a unique portfolio that looks a little or completely different from the index. 

The easiest way to do this is to look at the percentage weighting of different industries in the index and then use that as a template to replicate or deviate from when you create your portfolio.

A more technical approach is to use a variable called the Beta coefficient (yes, hello CAPM). Beta tells you how closely your portfolio tracks an index. It also represents how much extra risk and return your portfolio is expected to generate relative to the index. 

Now we can’t talk about Beta without talking about the mythical alpha. Alpha is when you make returns greater than expected for a given level of risk. In other words, it is Warren Buffet-level stock picking. Of course, this is easier said than done, and there is a reason the best active investment fund managers are paid top dollar. Caveat emptor!

Rule-Based Trading for Individual Stocks

One of the biggest risks in trading is a behavioural risk. Humans are herd animals, and sometimes the herd panics. But panic can quickly destroy years of hard-earned capital gains.

To combat panic selling or bandwagon buying, consider using rules to govern your trading. Many of these can be set up automatically using your trading platform.

Buying rules can include not buying a stock until it has fallen a predefined percentage below a target price from top brokers. This stops you from getting carried away with a stock’s runaway momentum. 

Looking at candlestick patterns and only buying when you see an upward pattern emerging is another type of rule.

Dollar-cost averaging is another type of buying rule that frees you from the psychology of the market in trying to buy an asset at a “perfect price.” Once you have identified an asset to buy, you simply buy a set dollar amount of it every week or month until you have reached a set dollar amount. So rather than buying the asset at a single price, you are buying at an average price, which has a better chance of being lower.

Stop losses are a type of selling rule. When a stock’s price falls below a target level, you sell. The aim is to decide ahead of time what gain or loss you are willing to live with.

You can also set yourself a trigger price on the upside. Sometimes it is wise to sell once a stock surprises on the upside. But don’t do this for growth stocks that have years of growth ahead of them. Rather use this for stocks that have struggled and which you have bought low. Once their share price recovers to a defined point, sell.

Final Thoughts

There is a reason we pay fund managers to manage our retirement savings, but for those willing and wanting to learn about investing, you can invest some additional savings in a personal investment portfolio. A lifetime of joy, frustration, and real rewards await! And who knows — maybe you will become a trading legend in your Reddit or Facebook group!

STOKR TEAM