Finance Diversification Ever heard the one about not putting all your eggs in one basket?That’s the idea behind diversification, one of the simplest and most effective strategies for minimizing risk. Building a portfolio comprised of different types of assets allows you to protect yourself against a downturn in any one. There are a number of ways to diversify: ▶▶ By asset – equities, bonds, cash, real estate, resources, precious metals, and so on. ▶▶ By geographic areas – North America, Europe, Asia, emerging markets, etc. ▶▶ By market capitalization – large-cap, mid-cap, small-cap, micro-cap. ▶▶ By management style– growth, value, momentum, market-neutral, etc. Awell-constructed portfolio is diversified across all these methods. Dollar-cost averaging An old strategy, but a very effective one for dealing with market risk, and with credit risk on the fixed-income side. By following a dollar-cost averaging strategy, you contribute to your investment account on a regular basis, thereby averaging out the purchase price over time. With this method, a temporary market decline isn’t necessarily bad news – it actually means that your regular contribution will buy more. When the market rebounds, the gains will be magnified in your portfolio, leaving you with more units at a higher price after buying low. Invest in equities A lot of retirees think that the best way to deal with business andmarket risk is to avoid the stock market altogether. But such a strategy ignores what could arguably be a more significant risk: inflation risk. The best way to fight inflation risk is by investing at least some portion of your portfolio in appreciable investments that have a growth component which stays ahead of inflation over the long term. Blue-chip, dividend-paying stocks fit the bill here: not only do these have the potential to grow faster than the rate of inflation, the income which they generate often grows as the underlying business increases sales and profits over time – something that rarely happens with bonds, GICs and similar investments. Hedging strategies The best strategy for managing risk in your portfolio is to avoid it in the first place – this is the central point of diversification and other strategies. When that isn’t possible, there are a number of strategies that seek to “hedge” risk and minimize its impact on particular positions in your portfolio. In the simplest example, investors can purchase “put” options that give them the right to sell a given stock at a given price, thereby minimizing the impact of both business and market risk for a given period of time. Hedging is a complicated strategy, best suited to sophisticated investors with large positions in highly liquid stocks. For the rest of us, it’s usually best to delegate such responsibilities to a professional manager with a good deal of experience, usually via a hedge fund or similar pooled investment. Professional management Many investors have neither the time nor the inclination to manage the various risks which their portfolios face on a daily basis. Nothing wrong with that – you can work with a qualified wealth advisor who can do it for you, or put your money into mutual funds run by experienced experts, or hire a high-level manager to build a bespoke portfolio. Not only does this delegate much of the “chore” of portfolio management, it’s also one of the most effective methods for managing risk. Strategies for managing risk So, now that you know about all of the possible risks which you face as an investor, how do you manage those risks? How do you ensure that excessive risk doesn’t derail your portfolio, or prevent you from reaching your financial goals? While there is no “magic bullet” strategy that can eliminate all risk, there are several ways to reduce the effect of risk on your portfolio. They include: CSANews | SUMMER 2016 | 29
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