Mitigating risk is an important exercise for any investor in order to preserve capital. The main objective of any portfolio is maximum returns, however this can only be achieved if risk is managed correctly. In this article we outline four ways to reduce risk and therefore optimise performance.
1. Calculating beta
One way to mitigate risk in the portfolio is the look at the beta of each stock. Beta measures how the stock fluctuates compared to the broader market. A stock with a beta of 1.00 means there is a positive correlation with the market. A beta of above 1.00 means this stock oscillates much more than the market does, which demonstrates that this is a risky stock. A stock with a beta of less than 1.00 means the stock moves less than the market. A stock with a high beta may mean higher risk but it can also can mean higher return. Small cap stocks and technology stocks tend to have high betas. Low beta sectors include consumer staples, healthcare, utilities and telecommunication.
Investors should consider calculating the beta for their whole portfolio to determine their overall risk in the market. To calculate this portfolio beta, you need to calculate the weighted beta of each particular stock. For example, an investor might have $2000 worth of CBA in a portfolio of $10,000 stocks, so your weighted beta is 0.2 ($2000/$10,000) * 1.27(CBA’s Beta) = 0.254. You can do this for all your stocks and then calculate the overall portfolio beta by adding up all the weighted betas. You can analyse which stocks are particularly risky in the portfolio and see if it has been balanced out with other lower beta stocks from looking at the total weighted beta.
2. Reduce positions on risky stocks
Only risk what you can afford to lose. If a stock is very volatile, reduce your position size so you only lose a smaller portion of your capital if the trade does not work out. Stocks in less risky, defensive sectors can afford a larger position size as the stock will not move up and down as much. Risking a smaller capital on a volatile stock will also allow the investor to sleep better at night and prevent the investor from making rash decisions.
3. Stop Losses
Another method to preserve capital is to implement stop losses. You can input these stop losses on the trading system so they are automatically generated or you can manually sell once the stock reaches your stop loss level. You can use technical analysis to determine support levels. If the stock moves pass that support level, then it may indicate that it will head lower so it is probably best to sell it.
Diversification of sectors in your portfolio will also reduce risk. If an investor is heavily concentrated in one sector, then if that sector has a turn for the worse, the portfolio suffers immensely. However, if the investor has diversified the portfolio successfully, then the risk should be spread out so there are some risky stocks as well as some stable ones. Investors should also remember that diversification of over 20 stocks does not reduce the risk any further. We have written on diversification on our blog previously in “The Benefits of Diversification”.
Uniquely combining both Fundamental and Technical Analysis
Not yet a subscriber? Join now for FREE!
Receive our weekly tips and strategies into your inbox each week.
BONUS: Sign up now to download our 21 page Trading Guide.
Lauren Hua is a private client adviser at Fairmont Equities.
Would you like us to call you when we have a great idea? Check out our services.
Disclaimer: The information in this article is general advice only. Read our full disclaimer HERE.
Like this article? Share it now on Facebook and Twitter!