The risk of an entire investment portfolio is always less than the sum of the risks of its individual parts. Many investors lose sight of that fact when making investment decisions. When adding an additional security to your portfolio, you might look at the risk of the additional security only, not at its ability to reduce risk overall. In this article, we'll explain how you can make your portfolio safer by adding risky investments. (See also: Personalizing Risk Tolerance and Managing Risk and Diversification.)
Reduce Risk By Incorporating Risky Strategies
Shorting a stock is always considered a risky strategy. You can, at best, make a 100% return on the position if the stock declines to zero. In theory, the losses are infinite if the stock continues to rise. For example, if you shorted a $10 stock and it climbed to $50 you would lose five times your original investment.
Similarly, buying a leveraged inverse ETF is also risky. For example, the ProShares UltraShort S&P 500 ETF aims to provide performance that is the inverse of, and double that of, the Standard & Poor's 500 Index. So if the S&P 500 rises by 1%, the leveraged inverse ETF should fall by 2%; and if the S&P 500 falls by 1%, the inverse ETF should rise by 2%.
The above strategies would be considered risky, but if done properly in a portfolio context, you can reduce your risk instead of increasing it. For example, if you hold a large position in a stock that you cannot sell, by shorting the same stock in an equal amount, you have effectively sold the position and reduced your risk of the stock to zero. Similarly an investor with a portfolio of U.S. stocks can reduce their risk by buying the appropriate leveraged inverse ETF. A 100% hedge will insulate you from risk, but it will also effectively reduce your exposure to any upside. (See also: Inverse ETFs Can Lift a Falling Portfolio.)
Buying Insurance With Options
A put option is a risky investment that gives you the right to sell a stock or an index at a predetermined price by a specified time. Buying a put option is a bearish strategy because you believe the stock or the market will go down. You make money on a decline, and the most you can lose is the price you paid for the option. Given the leverage of an option, it would be considered a risky investment. However, when a put option is paired with a stock that you currently own, it provides protection against a lower stock price. Unlike hedging, which limits your upside, buying a put would still provide you with unlimited upside. It is, in effect, like buying insurance on your stock, and the cost of your put option is the insurance premium. (See also: Options Hazards That Can Bruise Your Portfolio.)
Using Low-Correlation Assets
A portfolio consisting mostly of bank stocks and utilities is considered relatively safe, whereas gold and gold stocks are generally considered risky. However, buying gold stock rather than another financial stock might in fact lower the risk of the portfolio as a whole. Gold and gold stocks typically have a low correlation with interest-sensitive stocks and, at times, the correlation is even negative. Buying riskier assets with a low correlation with each other is the classic diversification strategy. (See also: Introduction to Diversification.)
Reducing Benchmark or Active Risk
Which is considered the riskier portfolio: one that contains 100% U.S. Treasury bills or one that has 80% equity and 20% bonds? In absolute terms, T-bills are the definition of risk-free investment. However, an investor might have a long-term asset mix of 60% equity and 40% bonds as their benchmark. In that case, compared to their benchmark, a portfolio containing 80% equity will have less risk than one with 100% U.S. Treasury bills. For the investor who has all cash, they can reduce their risk relative to their long-term benchmark by purchasing the risky equity.
The risk that your investment will not match that of your benchmark is called tracking error or active risk. The greater the difference in performance between the two, the greater the active risk or tracking error. One of the attractive features of index funds and ETFs is that they are meant to replicate benchmarks, thus reducing the tracking error to almost zero. Buying an ETF that matches your benchmark is always considered a safer investment than an actively managed mutual fund, from the perspective of benchmark or active risk. (See also: Active Share Measures Active Management.)
Understanding Your Real Risks
Many investors consider doing nothing a less-risky strategy than making a decision. However, as John F. Kennedy said, "There are risks and costs to a program of action, but they are far less than the long-range risks and costs of comfortable inaction." A safe investment portfolio of all cash will allow you to sleep at night, but can be considered a risky strategy if it falls short of meeting your objective.
In the long run, safe investments like bonds and cash will never protect an investor against the risk of inflation. Only by purchasing riskier investments like equities, commodities or real estate can an investor provide the protection they need against losing the purchasing power of their assets. In the long run, a portfolio of all safe investments will turn out to be too risky for protection against inflation.
Consider an American couple who lived in the U.S. all their lives, and then moved to Canada to retire. All the investments were left to be managed in a diversified portfolio of U.S. securities. Currently, all their expenses are in Canadian dollars. They now have exposure to a weak U.S. dollar. By investing some of their assets in "riskier" Canadian securities, or by hedging the U.S. dollar with currency futures, they are providing protection against a weak dollar and making their portfolio safer.
The Bottom Line
Many investors look only at the risk of their individual securities, not at the combined effect on their portfolio. In fact, portfolios can be made safer by investment strategies that by themselves might be risky, but that in the context of the entire portfolio can make it safer. This is especially true when confronted with the "real" risks that investors face long-term, such as inflation. (See also: Measuring and Managing Investment Risk.)