Portfolio Risks - Stock Risk Reduction Strategies
Given the risks outlined above, an IA can take advantage of the following risk reduction strategies to help protect his or her clients' portfolios:
Diversification - Diversification refers to investing in a sufficient number of different issues to minimize systematic (market) risk. It is also discussed in the Portfolio Management Strategies section as part of the asset allocation process, where it refers to the process of investing in different types of securities, such as stocks of both large and small companies, or bonds from both corporate and government issuers.
Dollar-cost averaging (DCA)- This strategy calls for a fixed dollar amount to be invested in the shares of a stock or mutual fund on a periodic basis (typically monthly or quarterly). Therefore, the investor receives more shares when the security price is lower and fewer shares when the security price is higher. Assuming share prices fluctuate during the investment period, the end result is a lower overall cost per share over time.
DCA offers protection and opportunity in a sinking market. The article DCA: It Gets You in at the Bottom explains how.
- Income reinvestment - Interest and dividends from stocks as well as all types of mutual funds may end up sitting in a money market account earning very low interest until an amount sufficiently large to be invested accumulates.
A better strategy is to set up automatic income reinvestment programs like the following:
Mutual fund reinvestment - When investing in mutual funds, you can set dividends and/or capital gains to be automatically reinvested in additional shares.
Dividend reinvestment plans (DRIPS)- A plan offered by a corporation that allows investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date.
Learn more about the perks of DRIPS within the article: The Perks of Dividend Reinvestment Plans
Exam Tips and Tricks
Consider these sample exam questions:
An investor owns a small-cap stock with very low trading volume. The investor has a high level of:
- business risk.
- market risk.
- liquidity risk.
- purchasing power risk.
The correct answer is "c" - while there is also the potential of business risk, the best answer is liquidity risk because the question focuses on the low trading volume.
Assuming that prices fluctuate throughout the investing period, the use of dollar-cost averaging results in a:
- lower average cost per share.
- higher average cost per share.
- lower market price per share.
- higher market price per share.
The correct answer is "a": when prices are lower, more shares are bought, which results in a lower average cost per share.