How to Reduce Investment Risk
KEY POINTS
Your approach to investing has a direct impact on your investment risk
Diversification across asset classes, industries, security types, and individual companies is critical to reducing investment risk
Hedging can be utilized to mitigate specific investment risks
Welcome to Part III of our Investment Risk Management series. We invite to you read the first two articles in this series Types of Investment Risk - A Universal Guide, and How to Measure Investment Risk.
We previously defined risk in terms of being systematic or unsystematic. Such risks include, but are not limited to interest rates, inflation, foreign exchange, credit/default, counterparty, and liquidity.
Common methods utilized to measure systematic risk and its relationship to return include beta, alpha, standard deviation, R-squared, and the Sharpe ratio.
Now that we understand the types of risk and some of the common measurement techniques, it’s time to look at ways we can mitigate investment risk.
Diversification - Unsystematic Risk
Diversification aims to decrease portfolio risk by spreading the risk across multiple industries and individual securities.
Diversification can be utilized to reduce unsystematic risk. Such risks are not shared by the entire marketplace. Industry and company specific risks are unsystematic and include, but are not limited to strategic, competition, legal, regulatory, and operational.
Systematic risks cannot be diversified away as such risks impact the entire market as opposed to a single industry or company. Such systematic risks include, but are not limited to interest rates, inflation, foreign exchange, and war. Systematic risk can be reduced through hedging and asset allocation.
First, let’s differentiate between asset allocation and diversification.
Asset allocation is the allocation of your portfolio across different asset classes (e.g., cash, equity, preferred shares, fixed income, commodities, real estate, private equity, hedge funds). Asset classes are comprised of various industries.
Diversification can be achieved at the industry level and security level.
As an example, in 2001 many Enron Corporation (“Enron”) employees had their income, stock options, employer pension plan, and personal investment portfolio tied to Enron stock. Such is an excellent example of a non-diversified portfolio.
The ensuing collapse of Enron devastated such portfolios. The investors’ individual portfolio risks could have been decreased had they been allocated across different securities within the industry, other industries, and other asset classes.
There have been many statistical studies published aimed at determining the number of securities required to achieve the optimal benefits from diversification. Such studies will often conclude a range of 15-30 stocks constitute a well diversified portfolio. The inclusion of exchange traded funds would typically decrease the number of stocks required to achieve such diversification.
Stop-loss Orders
A stop-loss order instructs your broker to sell your stock when the price falls to a certain level. For example, you may buy a stock for $50 per share and want to protect yourself from any price declines greater than 20%. You could achieve this by putting a stop-loss order in at $40 per share. The broker will sell your position if the price falls to $40.
Stop-loss orders are not perfect. They may fail to work exactly as expected during periods of extreme volatility or if the security is thinly traded. The stop-loss may be triggered, but the actual trades may be executed at prices below that of the stop-loss order.
Index ETF - Currency Risk
Investing in an index ETF can hedge currency risk to a degree. For example, many of the companies in the S&P 500 transact a substantial portion of the business outside of the United States. Such transactions will settle in foreign currencies. This provides an imperfect hedge against currency risk. Imperfect as it does not hedge out a specific currency risk.
Currency Exchange Traded Fund (“ETF”) – Currency Risk
Currency ETFs provide the opportunity for investors to hedge their exposure related to a specific currency or multiple currencies. For example, if you were long Euro in your portfolio, you could invest in an inverse/short Euro ETF. Or, if you forecast the USD will depreciate against a basket of global currencies, you could invest in a currency ETF comprised of such global basket of currencies.
Investors can purchase these ETFs in their brokerage account which avoids the need to convert into the foreign currency or engage directly in derivatives trading (see below). The ETF strategy also benefits from being less expensive than converting foreign currency or derivatives trading.
Currency ETFs often invest in a combination of cash, cash equivalents, and derivatives (e.g., forward contracts). Therefore, ETF performance may vary from the actual currency movements.
Short Selling – Downside Risk
Short selling provides the potential to profit from declining prices.
It involves borrowing an equity or ETF and selling it at the current price. The strategy involves the purchase of the shares at a future date, ideally at a lower price than they were sold for, then such shares are delivered to the security lender.
A margin account is required to facilitate the strategy. The trading strategy can be riskier than traditional trading of long securities as there is theoretically no limit to the amount a trader may lose.
For example, the traditional long purchase of 100 shares at $10 would have a maximum loss potential of $1,000. However, if 100 shares were borrowed and then shorted at $10 for proceeds of $1,000 the loss could be many multiples of the initial $1,000 proceeds: a sudden and sustained price spike to $100 per share would equate to a $9,000 unrealized loss to the short trader.
The ultimate gain or loss on a short trade will also be impacted by the interest charged by the security lender with respect to the securities loaned.
The strategy is also prone to experiencing a short squeeze whereby the market pushes the current security price higher causing the short sellers to experience increasingly higher unrealized losses. At some point the short sellers may capitulate and buy shares to cover their shorts and cap their losses. This wave of buying can drive the prices up even higher.
Options – Downside Risk
Options give the holder the right to buy or sell a security at a specified price (strike price) on or before a specific future date. Call options give the owner the right to buy a security. Put options give the owner the right to sell the security. Strategies can involve writing a call or put option and buying a call or put option. We will highlight a common strategy utilizing put options on equities.
The purchase of a put option gives the owner the right to sell the sell a security at the strike price. Such provides downside protection from adverse moves in the security’s price. For example, if a stock was trading at $20 you may want downside protection for any price decline below $18. A stop loss is one way to obtain such protection, as described above. An alternative is to purchase a put option with an $18 strike price. The put is considered “in the money” If the stock price falls below $18.
Options become worthless if they are not exercised by their expiration date. Therefore, holders are at risk of losing the entire premium they paid for such options. The purchase of an option has virtually zero counterparty risk as such risk is borne by the clearing house (e.g., Options Clearing Corporation in the United States).
Forward Contracts – Multiple Risks
Forward contracts (“forwards”) are derivatives, negotiated between two private parties, and traded over-the-counter. Therefore, forwards are typically not available to retail investors. They can be linked to currencies, interest rates, stocks, commodities, and more.
Forwards allow the parties to buy or sell an instrument at a specified price on a future date. The contract is private and highly customizable compared to futures contracts (see below). The contract involves leverage as margin is posted as opposed to funding the investment account with the total notional value of the contract. The contract is subject counterparty risk as there is potential for either party to default.
Futures Contracts – Multiple Risks
Futures contracts (“futures”) are derivatives, standardized contracts, and traded on registered exchanges. Retail investors can trade futures by opening a margin account with their broker. They can be linked to currencies, interest rates, stocks, commodities, and more.
Futures are legally binding agreements to buy or sell a standardized asset at a set price on a specific future date. The contracts trade on exchanges and are standardized (i.e., non-customizable). The contract involves leverage as margin is posted as opposed to the total notional value of the contract. The contract is subject to minimal counterparty risk as the exchange acts as counterparty to both sides of the trade and all trades are marked to market daily.
Mitigating Investment Risk - Behavioral Traits
There are several behavioral traits that you can use to impact the overall risk of your investment strategy. The following is a sample from the long list of traits.
Dollar Cost Averaging
You will hear the adage that investors should not try to time the market.
What does that mean?
Buy low and sell high is everyone’s implicit investment goal. Some investors will attempt to time their investment purchases when they perceive the market to be at an ultimate low. Several studies have shown that few investors can consistently time the market. Such may lead to an over allocation to cash and lost profits as prices continue to rise while the investor continues to wait for a drop in price.
Dollar cost averaging is an alternative approach that helps lessen the impact of market volatility on your portfolio. It involves investing equal amounts at set intervals. For example, investing $1,000 per week for 4 weeks instead of investing $4,000 in a single purchase transaction.
Black Monday, October 19, 1987 is an excellent example of how investors can benefit from dollar cost averaging. The Dow Jones Industrial Average fell 22.6% on such date. A $10,000 investment at the market close on October 18, 1987 would have lost $2,260 the next day. Whereas investments of $5,000 at the market closes on October 18 and 19, 1987 would have resulted in a loss of $1,130.
Liquidity
Liquidity refers to the time it takes to sell a position and convert it into cash without negatively impacting its price. Cash is the most liquid asset; however, a portfolio consisting of 100% cash is unlikely to achieve your investment goals.
Each country has its own standardized settlement terms. For example, North American markets require equity and bond trades to settle in 2 days and government securities and options settle in 1 day. A one day or two day settlement period would qualify most of these securities as liquid.
However, settlement time is only one component of liquidity. The settlement process should not negatively impact price to ensure a high degree of liquidity. Penny stocks are an example of securities that can experience significant price declines on limited selling activity due to their thinly traded nature.
Several assets are prone to liquidity constraints including, but not limited to forward contracts, real estate, private equity, hedge funds with lock-up periods, privately held business, artwork, and jewelry.
Time
Your time horizon has a significant impact on your risk tolerance. Risk tolerance typically increases as the time horizon is extended. You can reduce your risk to the extent you are able to extend your investment time horizon. Such may not always be possible, but time can be a powerful force when flexibility exists.
For example, you will likely have different timelines associated with your various investment goals. You may have multiple milestone goals like a 2-year saving goal for a house and a 40-year savings goal for retirement.
A 2-year savings goal for a house may require an abnormally high savings rate and an overly risky investment plan designed to achieve above market rates of return. The volatility inherent with such elevated risk levels may prevent you from reaching your goal.
Alternatively, extending the time horizon from 2 years to 10 years may be viable option to reduce risk. On a related note, we invite you to read our article Should You Buy or Rent Your Home?.
Research – Review – Rebalance
These three R’s are an essential part reducing your investment risk.
Research takes a lot of time and effort. Fortunately, there are plenty of resources to draw from: on-line, brokerage firm, and your financial advisor. Once you identify potential investment opportunities, you need to determine how such may fit into your portfolio.
For example, you may choose to forgo an investment in an attractive technology stock as such would create an unacceptable level of concentration risk due to your pre-existing allocation to the technology industry.
A disciplined approach to regularly reviewing your portfolio is essential. Such includes reviewing asset class allocation, industry allocation, diversification of securities, and the individual investments. Such can be overwhelming for portfolios holding many positions. ETFs can be a great alternative if the number of positions has become unmanageable
We cannot accurately predict how markets and individual companies will perform over time. Therefore, weightings across asset classes, industries, and individual securities will change. The need to rebalance can be well satisfied if the proper research and reviews have been effectively incorporated into your approach.
Bottom Line
Investment risk is unavoidable, but it can be mitigated with the correct approach and tools. We recommend you work closely with your financial advisor to develop a structured approach to achieving your investment goals.
