Warren Buffett famously said that the first rule of investing is not to lose money. The second rule just points to the first. The only way you can actually implement this is by managing risk in your portfolio.
Risk is an inevitable part of every investment you make. It also determines the returns you can anticipate from your portfolio. Though you can choose the degree of risk you would want to take while investing in a fund, it may alter in the future according to the market and economic conditions. Apart from the market conditions, as your goals and risk appetite change, you might want to modify the risk of your portfolio.
While maximising returns is the ultimate goal of your investment, you cannot do this without adjusting your risks as per your requirements. Here are some strategies that top investors employ to manage their portfolio risk:
1. Develop a Plan for Maximum Potential Loss
The worst-hit losses are the ones you didn’t see coming. Hence, the most crucial step to avoid such draining losses would be to anticipate and prepare for them. Many equity investors cannot gauge the intensity of losses — leaving their portfolios vulnerable to bear markets and plunging economic conditions
A probable maximum loss plan would help you envision the risk of your portfolio in extreme loss markets and make informed investment decisions. Furthermore, it will help you to take calculated risks — suitable to your risk appetite and aligned with your long-term investment plan.
To breakdown the probable loss plan further, you need to analyse the asset allocation of your portfolio and the valuation of each asset. Only by valuing your holdings on a regular basis, you understand the risks that may cloud your portfolio and the adjustments you need to make to reduce any such risks. Let us discuss this in detail in our next point.
2. Focus on smart Asset Allocation
Efficient asset allocation (diversification) is one of the most fundamental ways to manage your portfolio risk. While asset allocation talks about the bigger picture and how the risk of one asset offsets or complements the risk of another asset in your portfolio, the emphasis during investing in assets should be on individual securities.
Do your research right or get professional portfolio analysis if required to find and invest in undervalued assets. Active portfolio allocation should be at the core of your investment discipline.
Even if you are satisfied with the way you have allocated investments between various investment groups and classes, you need to monitor your portfolio regularly and adjust it according to the current goals and conditions. Watch out for large price swings as they are your cue to change your asset allocation.
3. Ensure you have a margin of safety
Not only for the portfolio as a whole, but a margin of safety is also crucial for each stock or instrument in your portfolio. What is the margin of safety? Simply put, it is the difference between the intrinsic value of a security and the price you have paid for it—the larger your margin of safety lesser risk you need to assume.
A decent margin of safety will give you room to make mistakes, errors, experiments, or manage extreme economic conditions. Apart from investing in undervalued stocks, or getting huge discounts, creating a margin of doubt would also include buying stocks of good companies with proven track records and strong financial.
4. Stay away from Portfolio Volatility
If you are a beginner, on a surface level, portfolio volatility may seem to be inconsequential when balanced. For instance, if your portfolio has yielded a positive return of 50% and a negative return of 50%, a simple arithmetic average will show you got 0% ( seemingly no harm done). However, if you analyze properly, you have lost 25% of your portfolio.
Hence, in the long run, higher volatility can cause significant damage to your portfolio returns. It is only prudent to balance your portfolio volatility because the less volatile portfolios almost always outperform the more volatile ones.
5. Prioritize Liquidity
While strategizing to minimize risk, you also need to consider the duration risk, implying that over a certain time, a few investments can grow more sensitive to stock market changes. Liquidity is also vital because cash allows you to take advantage of the market cycle.
For instance, if the market is headed to an extreme downturn due to which even valuable stocks are available at discounted rates, you will not be able to invest in them if you don’t have cash with you. Hence, it is always necessary to account for liquidity while building your portfolio risk plan.
6. Refrain from Emotional Thinking
We all are emotional beings, and our emotions have always reflected in the tasks we perform and the decisions we make. However, while investing, there is no scope for emotional decision-making — it is strictly a number game. Don’t make major investment decisions based on hear-say or the headlines. Make sure you take to construct your portfolio after performing a comprehensive risk analysis and looking at the correlation of the assets in your portfolio.
7. Analyse your timelines
Remember investing is not a sprint but a marathon. Think about long-term profits while investing and do not try to outperform the market in a short period. Get your timelines for investing right and align them with your financial and personal goals. If you rush to beat the market, you may end up losing a significant part of the portfolio. To sum up, a healthy portfolio is one which has its risks constantly evaluated, identified and mitigated. Such portfolios tend to build long term wealth for the investor.