The share market is the best performing asset class over time. It is however, the most volatile. It is a reality that you will have losses along the way. The key of course is to minimise those losses as much as you can. There are several strategies which can be implemented to reduce losses in your portfolio. Higher risk means higher return but the risk can be mitigated by using some of the following methods.
The 5 ways to reduce losses in your stock portfolio are:
- Stop losses
- Use ETF’s
- Hedge with options
- Selling strategies
Diversification helps to reduce risk by investing in different sectors which do not perform in the same manner. Therefore, if one sector in the stock market performs badly then other stocks in other sectors can offset those losses. It is always risky to be overweight in one particular sector because if that sector performs badly then your portfolio will take a big hit. This will make your portfolio more stable as you can limit the amount the volatility you want to take. However, be careful not to overdiversify as 20 stocks is the optimal level of diversification. Any additional stock does not reduce your portfolio risk by much. We wrote about the benefits of diversification on this blog previously.
Stop losses or trailing stops
You can limit the amount of loss you want to take on stock by putting in a stop loss. Once a stock drops to the stop loss price, your trading system should automatically sell your stock position. This will limit the losses you will take on a particular stock position. Trailing stops are also another risk management tool which can used. These stops trail the stock higher and get recalculated off the new highest price. You can select the trailing level you want to take depending on the stock. For example, a 10% trailing stop will ensure that you will get stop out of the stock if it falls 10% off the highest price. You can select either highest closing price or intraday price depending on the trading platform you use. This method will ensure that your stop loss moves up if the stock price moves up. Just bear in mind regular stop prices are not guaranteed due to issues such as gapping and liquidity. Therefore some platforms offer a “guaranteed” stop loss for a small fee.
You can use ETF to hedge your portfolio by shorting the market. Therefore there are ETFs in the market where you profit when the market declines. Such ETFs include BEAR which tracks the S&P/ASX200 accumulation index and profits when the market drops. There is also BBOZ which is similar to BEAR but is magnified where a 1% fall in the market will generate a 2% to 2.75% gain in the fund. And for the US market, there is BBUS where a 1% fall in the S&P 500 Total Return Index will generate a 2% to 2.75% gain in the ETF. If the market is on a decline and you have some poor performing stocks, then you can use ETF to hedge a portion of your portfolio and still profit when you have losses in your other stocks.
You can also hedge your portfolio with the use of put options. If you own a stock and it goes down in value, the put option could offset these stock losses. A put option is purchased when the price of a stock is expected to go down. The owner of a put option has the right to sell the asset at a price at a specified date. Hence if the stock does go down, then the owner of this put option may exercise their option and sell their stock at the price agreed. If the stock price goes up then this put options owner can let the option lapse but will profit from their stock minus the premium they paid for the option. We have also written up an article on options on this blog called “A beginner’s guide to writing covered calls”. Covered call writing is another method of hedging your portfolio.
If you have strategy of when to sell, then it will take the emotion out of investing as you have a plan of when you want to be out of the trade. You can use technical charts to select a level to take profits or losses and trade with that strategy in mind. This will prevent holding on to losses in the hope they will recoup which means potentially losing an even greater amount of money.
Lauren Hua is a private client adviser at Fairmont Equities.
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