Balancing Risk in Your Portfolio
For investors, Risk and Reward are two sides of the same coin. The lower the amount of risk in a portfolio, the smaller the reward it is likely to give you. The inverse is also true: Higher risks often yield higher rewards.
While traders, high-net-worth individuals or younger investors with "gambling money" to lay on the line may prefer high-risk investments, most retail investors would prefer portfolios that have a balanced risk/reward ratio.
Here are some tips on how you can balance the risk in your portfolio:
- Know your risk appetite: When you first meet with an investment adviser (and regularly thereafter – often at least once a year), he/she will go through what's called a "KYC" (Know Your Client) questionnaire. Part of that questionnaire deals with your risk tolerance. If you are a "DIY" (Do It Yourself) investor, there are many free online resources that do the same. Once your appetite for risk has been determined, you (and/or your advisor) can then build a portfolio around your Risk Score.
- Know your investment objectives: Balancing risk and reward is a function of your risk appetite and your investment objectives. The shorter your investment time horizon, the higher amounts of risk you'll have to take to achieve your investment goals. If, on the other hand, your only concern is preserving your capital, you might be satisfied with low-risk, low-return investments. How you balance risk in the portfolio will therefore depend on what you want to achieve at the end of your investment horizon.
- Diversifying your risk: One of the classical ways of balancing risk and reward in a portfolio is to design a portfolio that balances risk appetite (tip 1) with reward expectations (tip 2). And the best way to do that is to diversify your portfolio appropriately between risk-assets and reward-assets. Generally, in a "normal" investment environment, Bonds, CD's and Dividend-paying blue-chip equities are viewed as "safe" investments. High-yielding bonds and growth-oriented stocks may be classified as "riskier" alternatives. Striking a balance between these two asset classes is the objective of diversification.
- Look for alternatives: Holding an array of alternate investments in your portfolio is also another way to balance risks. Rather than putting all your money into a discount brokerage/trading account holding individual stocks, owning a collection of well chosen Mutual Funds, ETF's, Real Estate Investment vehicles, Currency Investments, Bonds and CD's in a portfolio can serve as a great tool to balance portfolio risk. Investing directly in some of these asset classes (for instance buying Gold or Property) might also be a great way for some investors to hedge their risks.
- Get technical: Not many investors like to delve too deeply into technical territory when deciding how to balance between risk and return. However, for technical-minded portfolio builders, looking at the Risk Index (Standard deviation) of an investment might help determine if it is an investment worth taking a risk to hold in your portfolio. All things being equal, the higher the standard deviation between 2 investments producing the same rate of return, the higher amount of risk you'll take earning those returns. Studying the risk-adjusted-returns of an investment will aid in your risk balancing decision.
- Survey the universe: Balancing risk in your portfolio is not an exercise that should be done in isolation. Your portfolio has assets that are part of a bigger universe of investment assets. Unless you know how much more (or less) riskier (or rewarding) some of those other investments are, you'll never be able to balance your portfolio optimally. Compare your investments against peer investments of the assets held in your portfolio. Additionally, compare them against credible benchmarks to see what other risk/reward opportunities are available to you.
The re-balancing act
If you have a suite of well diversified investments, then managing risk in your portfolio should not be a minute-by-minute or day-by-day activity. Quite the contrary! Investors who look at balancing risk in their portfolio too often end up with a poor performing portfolio (and exorbitant trading fees!). While encouraging you to stay engaged with your investments, professional portfolio advisers would endorse an annual or semi-annual portfolio review in order to make risk/reward balancing decisions.