Sometimes investors have to get creative when it comes to mitigating equity risk, particularly if they are uncomfortable or against investing abroad. Mitigating risk within domestic equities presents some challenges, but there are some strategies that can be used to fortify a portfolio in trying economic times. Here, we'll provide five strategies for mitigating risk without moving your funds abroad. (For more on this topic, read Mitigate Your Equity Risk.)
1. Rebalancing/Sector Diversification
Far too often, investors construct their portfolios in an incorrect fashion. That is, they put too much emphasis, or weight, of their holdings in one particular sector. Or, even if they do pursue a balanced investment strategy with adequate exposure to broad sectors within the economy, over time they fail to rebalance it based upon market activity.
Generally, investors encounter this rebalancing error when they find one stock that has done particularly well and comes to make up a large percentage of their overall portfolio. They will often fail to counterbalance that position with one or more offsetting positions. Or, they'll fail to reduce their holdings in that position to ensure that the portfolio remains balanced according to the investor's risk tolerance. (To learn more about balancing your portfolio, see Rebalance Your Portfolio To Stay On Track and A Guide To Portfolio Construction.)
Investors should consider holding stocks in a variety of sectors and make certain that those holdings remain balanced and in proportion to each other over time. This way, even if the domestic market does take a hit, investor won't be overly concentrated in any one sector. This should help stem losses. (For more, see Choose Your Own Asset Allocation Adventure.)
2. Buying Bonds/Money Market Instruments
While stocks have historically outpaced most other investment vehicles over the past 100 years, there are times like when bonds - and even money market instruments - have outpaced equities. Because of this, some exposure to these securities makes sense as there can be some comfort in receiving a consistent income stream even in a down market.
Those seeking long-term capital appreciation should still keep a sizable percentage of their portfolios invested in equities, but including a bond element can help smooth some of the rough patches.
There is no simple answer to what percentage of one's portfolio should be made up of bonds because this depends on a number of factors, including:
- Risk tolerance
- Need for income
- Investor's tax bracket
- Quality of securities purchased
- Market conditions
- Investment horizon
One trick that some advisors and investors use for determining appropriate stock and bond holdings for a portfolio revolves around this simple strategy:
|Example - Determining Percentage of Bond Holdings
An investor will take his or her age and subtract it from 100. The resulting number is supposed to be the percentage of stock holdings the person\'s portfolio should contain. The remainder should be bond and money market holdings.
So, if Bob is 30 years old, he would subtract his age from 100 resulting in 70. Therefore, 70% of his portfolio could go toward investing in equities. The balance (30%) could then be invested in bonds and money market instruments.
Please note that this equation is oversimplified and inexact on an individual level. Therefore, while investors can use it to get a sense of how their portfolios should look, they should also consider their individual circumstances before constructing or altering any portfolio and should consider consulting a financial advisor.
Investors, like infantrymen, should always try to keep a little gun powder dry, or keep a little cash reserve as a hedge against a market correction. If nothing else, it will provide funds to invest and to buy stocks if and when the market does decline and opportunities become plentiful.
The question as to how much should one should hold in cash, or money market instruments, depends upon the investor's individual situation, and current holdings. That said, some advisors recommend keeping as much as 10% on the sidelines for such opportunities.
3. Hedging With Options
While stocks have historically been a great place to invest, there are times when certain individual sectors come under pressure as the result of a company-specific event or prevailing market conditions, causing this asset class to underperform. (To read more about this, see Understanding Cycles - The Key To Market Timing and The Greatest Market Crashes.)
There is a way for investors to potentially mitigate this risk, or a portion of it, without having to liquidate their holdings through the use of options. Investors can hedge their risk (in certain positions) by buying puts on a particular stock or index (therefore betting that the stock or index will decline in value). As an alternative, they may also be able to sell call options on some equities and/or indexes in order to obtain income. (To keep learning about hedging, read A Beginner's Guide To Hedging.)
Options are not for everyone, though. Investors should fully understand how options are used and the full extent of their leverage before considering buying or selling any option. one must also keep in mind that some securities do not have or trade underlying options.
4. Diversifying with Large Cap Stocks
In periods of turmoil individuals and institutional investors tend to gravitate toward quality, typicaly large cap stocks. These companies generally have deeper pockets (in terms of cash reserves), generate more income and cash flow, and are more diverse in terms of their geographic footprint than their mid cap or small cap counterparts. They are considered to be more likely to weather an economic downturn.
Investors should consider allocating a portion of their assets toward these types of securities. They should also consider limiting their exposure to development stage and/or bleeding-money companies especially during periods when macroeconomic conditions begin to deteriorate.
5. Avoiding Companies that Depend on Discretionary Income
In trying economic times, companies and stocks that specialize in necessities have a tendency to fare better than those that do not. Companies that rely on excess discretionary income, like car and luxury goods companies, don't hold up in times of consumer pressure. Companies that sell breakfast cereals, foodstuffs and pharmaceuticals will generally hold up during any economy fizzle or sizzle - after all, everyone needs foods and drugs regardless of what the economy is doing.
Incidentally, "sin stocks" tend to fare pretty well in market downturns. Athough these are not the most socially responsible investments, they seem to stand on solid ground when other stocks are crumbling.
While investing overseas can be a terrific way to minimize or spread out investment risk, there are times when individuals either cannot or prefer not to invest abroad. When that is the case, it makes sense to consider some of these strategies and keep your funds, risk and profit in your country's market.