Fundamentally, investing is all about accepting and managing risk. And, in exchange for the level of risk you take on, you receive commensurate returns.
“Riskless” assets like cash and Treasuries offer the lowest returns, while small-cap stocks, emerging markets, and more speculative investments offer greater risk as well as proportionately higher upside potential.
The challenge, for all investors, is finding an appropriate balance – a level of risk you’re willing to accept to generate the returns you hope to achieve.
Most investors do not consider risk management when initiating a new position. Instead, they all too often find themselves caught up in the moment when a position turns against them.
Unfortunately, that moment tends to be the most emotionally charged and it all too often turns otherwise rational investors into panic sellers.
So, to get ahead of the next inevitable downturn, here are four strategies that investors can use to manage and reduce the risk to their investments.
1. Trailing Stop-Loss
We have all been there. You buy a stock or fund and it appreciates in value rapidly. Then it stumbles and begins to decline. What do you do? Should you buy more, let it ride, or sell?
Save yourself a lot of pain and agony by following a simple rule. If a position ever falls more than 25% from its high, sell it immediately and reassess the situation.
Some may counter that this 25% rule is a bit arbitrary but no doubt a 25% decline from a high is about as much stock investing risk as most investors can handle. This sort of decline also indicates that the fundamentals have broken down and it’s time to pause and revisit a holding. More risk-averse investors may want to have a tighter stop-loss policy set at 10% to 20%.
2. ETF Put Options
Many ETF investors are unaware that roughly 40% of ETFs have options that can be used to hedge positions. For some ETFs, option maturities go out as far as four years.
The easiest way to find out if options are available for a specific ETF is to go to Yahoo Finance and put in the ticker. On the left side will be a menu. Just click on the “options” link and, if options are available, they will come up for review.
Before jumping into options trading, you should consult with your financial advisor and do some research on the basics. You can keep it simple like checkers, or get a bit more sophisticated like chess. If you have large positions that cannot be hedged in something like a retirement account or an equity stake with an employer, consider sector ETFs as a partial analog for hedging individual stocks.
3. Cash
Many investors have a hard time holding cash in a portfolio. Cash has to be put to work for a portfolio to grow but it is a lot smarter to do it gradually than to throw it in the market at once.
Likewise, going 100% cash in your portfolio is almost always a blunder. But in a sharp market downturn when your positions hit their stop limits, let some cash accumulate and then follow a calm plan to put it to work.
As Warren Buffet puts it, when great stocks are on sale, you need to back up the truck of cash rather than use a thimble.
4. Inverse ETFs
You should also be aware that there are exchange-traded funds (ETFs) that move opposite the markets. For example, if you had a very strong belief that emerging markets were very overvalued, you might consider hedging your positions with ProShares Short MSCI Emerging Markets (EUM) which moves opposite the MSCI Emerging Market index. There are inverse and leveraged ETFs out there on a wide range of assets from oil to gold to Treasuries.
Use these carefully since they are not meant to be long-term positions but rather short-term allocations in times of volatility, whenever they return.
It will help to stay optimistic and adhere to your financial plan if you use some of these strategies. Keep calm with these portfolio shock absorbers. They will help you manage risk and avoid panic selling.