The key take-away when looking to do effective risk management on a portfolio is that the absolute (equity) exposure is important, but so is the risk profile of the investments, says Todd James.
Most investors understand and monitor concentration risk in their portfolio (if they don’t they should). But most of us look at it from a simple one dimension: capital invested in one security.
But if we look a little further, if stock ABC was twice as volatile as BCA, then from a risk perspective we have a somewhat balanced portfolio. This raises an interesting and useful tool for individuals to manage the risk within their portfolios.
A better understanding of risk
Too often investors, advisers and even portfolio managers select a basket of stocks and then weight them according to an index, their expectations of performance, or worst yet, an equal weighting. This might be okay from a capital perspective, but not from a risk standpoint.
Without getting too technical, we can simply look at the most recent historical volatility of each stock we are invested in and adjust weights accordingly. We can use rules-of-thumb rather than hard-core mathematics to guide us in our portfolio weightings.
If the average volatility of stocks within a portfolio is 15%, we can scale up or down individual weightings based on each stock’s relative volatility. Thus, a stock with a 10% volatility will have a greater weighting than a stock with 20% volatility. Maybe it’s twice as much, or maybe only 25% more, the point is there is some weighting based on risk rather than just capital.
This will help balance your portfolio from a risk point of view, and in some cases, allows you to take on more equity exposure than you might normally be able too.
For example, portfolios with 50% invested in equity can and will have significantly different risk profiles depending on the specific investments in each portfolio.
For investors that invest in funds, not all funds are equal either. So make sure you understand the risk exposure (or volatility of each fund); it might be prudent to invest in lower volatility funds rather than just outright lowering exposure by selling them, and vice versa.
Practically speaking, this works well from a risk management perspective, but unfortunately when a market goes up, normally the higher volatility stocks will outperform, so performance may lag, even if on a risk-adjusted basis you are doing better. Unfortunately, most individual investors do not look at a risk-adjusted returns.
So instead of using this process to decrease exposure to high-volatility stocks, use it to increase exposure to lower volatility stocks. If you are not overly-exposed to equities already (given your individual risk profile), then allow an increase in equity exposure by investing in lower-volatility stocks and funds.
In an environment with such low interest rates, I don’t see the point of holding cash within a portfolio, other than as a risk management tool. So instead of cash or low (negative) yielding bonds investing in lower-volatility equities can be a good alternative.
Another benefit may be that many of these “boring” stocks also pay a reasonable dividend, which can add a marginal fixed income element to a portfolio (which shouldn’t be ignored).
There are many ways to manage the risk exposure of a portfolio, by simply turning up or down the absolute equity exposure is far from the only alternative.
Contact Todd: [email protected]
Global Markets, Wealth Management Training
You might be interested in
