How does one control portfolio risk, assuming this is not a forgotten principle? Return and risk are co-equal branches of portfolio management. Keep in mind it requires a recovery of 100% if there is a loss of 50%. Working risk controls into your portfolio management model becomes even more important as the years remaining for recovery are reduced. As one ages, risk controls become more important as there are fewer years left to recover losses.
Here are several risk controls to employ when it comes to portfolio construction and management.
- Diversify by including different asset classes. As I suggested in an earlier blog, begin by investing 100% of the portfolio in U.S. Equities such as SPY, VTI, or SCHB. To continue to put all your money in equities is risky. Therefore, begin to diversify by investing in bonds. This is known as the stock/bond ratio. If you are in your 20’s, consider an 80%/20% ratio.
- A second averse risk move is to consider what percentage to invest in a given security. Within the Kipling spreadsheet is a worksheet that aids the user in knowing how many shares to invest in a particular ETF or mutual fund. This is known as the Position Sizing worksheet.
- Diversification is automatic if one uses ETFs or index mutual funds. This is a fast way to reduce portfolio risk.
- Another way to limit portfolio risk is to use stop loss or trailing stop loss orders. To understand this requires a little more investigation than I provide here.
- Set the overall portfolio risk percentage. Once more, this can be performed or adjusted within the Kipling spreadsheet if one is using this investing tool.
- Focus on low volatile or low beta securities. The Kipling spreadsheet provides a beta reading. Use it.
- Apply variables available within the Kipling spreadsheet as there are multiple ways to hold down portfolio risk. However, keep in mind that reducing risk almost by definition will reduce portfolio return.
- Seek securities that are not highly correlated. While it is difficult to find asset classes that have a negative correlation, unless one shorts the market, it is possible to reduce risk by working with low correlated ETFs.
There you have a few suggestions to help control overall portfolio risk. Most of these suggestions can be activated within the Kipling spreadsheet and examples are provided in the various portfolio reviews.