Five ways to manage your portfolio risk
Portfolio risk management sounds a lot more complicated than it actually is. In essence, it is just another way of describing money management, but with an emphasis on choosing a balanced portfolio of investments. This degree of ‘balance’ helps to deliver a reasonable income without exposing you to an unacceptable amount of risk.
Everyone has a different idea of what constitutes acceptable or unacceptable risk. Conservative investors are usually averse to any sort of risk, while aggressive investors tend to be a lot more comfortable with the idea of losing money if it means they get access to potentially higher returns.
How you calculate your portfolio risk will very much depend on your own financial goals, and how much time you can afford to dedicate to portfolio management. If your goals are relatively straightforward — for instance, long-term saving for retirement — then there is no reason why you can’t manage your portfolio risk yourself. However, more complex financial arrangements (for instance, day trading or multi-currency plays) may require professional financial advice.
Read on to learn the five basic steps to managing your portfolio risk.
How to manage your portfolio risk
Diversification is the key to managing your portfolio risk. A diversified portfolio will spread your funds across a variety of different asset classes, institutions and geographies. For most investors, this means splitting the majority of their portfolio between equities and bonds, with a certain amount held in cash to act as a cushion in times of volatility. Other investors like to carve out a portion of their portfolio for alternative investments such as private equity, hedge funds and emerging market equities.
Watch now and learn more about the power of diversification
To maintain balance, try to think about the worst case scenario for each one of your investments, and work a safety net into your portfolio. For instance, if you are heavily invested in the stock market, what will you do if the markets crash? Fixed income, cash and debt instruments may offer lower returns than equities, but they tend to hold their value even during times of financial instability. By investing some of your money into debt, you can effectively insure yourself against any volatility in the equity portion of your portfolio, thus minimising the overall risk of losses.
- Keep your fees down
Management fees and taxation can eat into any profits made through your investments — and if your portfolio is making single-digit returns at the end of the year, these costs risk making a huge difference to your actual investment income.
Keep as much of your money as possible by investing via tax-free wrappers such as ISAs and self-invested personal pensions (SIPPs), and choosing low-fee trading options such as exchange traded funds (ETFs). Most ETFs charge less than 0.5% in fees, so you won’t be hit with an unexpected bill at the end of the tax year. By minimising your fees and taxable charges, you can build and maintain a lean portfolio which delivers clear results.
- Go mainstream
When you are investing in individual stocks and shares, there is always a temptation to save money by avoiding expensive stocks such as Apple or Google and seeking out cheaper, smaller companies that seem to have a lot of growth potential. However, there is a reason why these big blue-chip companies are so expensive — they deliver for their investors.
FTSE 100 and S&P 500 companies tend to have a long track record on the stock market, and many investors find this reassuring. While past performance is no indication of future returns, it can help would-be investors to build up a picture of a company and how their shares react in times of volatility.
If you aren’t sure which blue-chip stocks to choose — why not invest in them all? There are numerous ETFs and investment funds that track the performance of an index, such as the FTSE 100, FTSE 250 or S&P 500. By following a mainstream equities strategy, you are minimising the risk of betting on a less stable company that could disappoint in the long term.
- Avoid leveraging
‘Leveraging’ means using borrowed money to make short-term investments to help maximise your returns. It is risky and can see your losses multiply in the blink of an eye. There are now many leveraged ETFs on the market and these should be approached with care.
Remember — no investment is guaranteed, and if you are engaging in high-stakes trading, you should only ever invest money that you can afford to lose. For responsible investors, leveraging should represent an unacceptable risk in their portfolio, regardless of the potential gains that can be made.
- Stick with what you know — or get expert advice
It might be tempting to go after the big returns promised by cryptocurrency investments or the Alternative Investment Market (AIM). But unless you have an expert level of knowledge about these areas, they can represent a big risk area on your portfolio.
As a general rule, you shouldn’t invest in anything that doesn’t make total sense to you. If you are struggling to explain how hedge fund investments work, you may not be ready to invest in them. However, this doesn’t mean that you should avoid complex financial instruments altogether — there are plenty of qualified financial advisors who can help you navigate the world of high-risk, high-reward investments. You can also seek out robo-advice online for a quick insight into your individual risk profile and suggested allocation split.
Good financial advice is well worth your time and money, as it can help you to make more informed decisions about your finances. And the more knowledge you have, the more risk-aware you can become.