Too often, investors look only at valuations – but never consider the overall risk of their portfolio. None the less, risk management is a vital tool for the private investor. Understanding risk allows you to avoid or mitigate risks you don’t want to run, while accepting those risks you believe are justified.
Before you can manage your risk, you need to understand it. You need to look at your entire portfolio; and by this I don’t mean just your equity portfolio, but your whole asset base – house, cash holdings, funds, the lot. If for instance you have a £1m house, and only a £10,000 equity portfolio, then do you really think you should be holding housebuilders’ shares? If you have a large lump sum sitting in cash, then you can afford to take more risk with your equities – if one of your high-flying tech stocks comes down to earth with a bump, it won’t kill you. Get a feel for the overall proportions of different assets in your asset base, and the relative levels of risk.
The next stage should be to look at your equity assets. For many investors, I’d say look at your fund holdings as well as equities, and take a good look at the portfolio breakdown your fund statements give, and in particular their top ten holdings.
Look at the proportion of equities you have in each sector against the benchmark. Consider how much of your portfolio risk management is in each sector compared to the benchmark, and how much is in each geographical area compared to the benchmark. Now unlike some fund managers, you are not obliged to benchmark – indeed, to beat the index, obviously you shouldn’t! But you should look at your divergence from the benchmark and ask whether it’s a good idea. You might, for instance, say “Yes, I’m happy with no banks in there – I think there are more toxic assets and there’s more bad news lurking, waiting to come out,” but you might also say “I probably ought to get an emerging markets investment trust or ETF to get some exposure, for the longer term.”
Another way of looking at risk is to look at the risk profile of each individual stock. To do this, you need to look at their betas – the coefficient that measures the divergence of returns from the norm. A stock that is more volatile than the market has a beta of above 1 – a ‘high beta’ stock. Conversely, a stock with a beta of less than 1 will tend to move less than the market.
Now high beta is not ‘good’ or ‘bad’. A high beta stock represents a high risk, but also represents a high potential return. If your objective is capital growth, you have adequate savings besides your equity portfolio, and your future wealth is not entirely dependent on your equity investment, then you could embrace high beta with no qualms. On the other hand if you’re retiring in a couple of years’ time and you’re going to be living largely off the income from your equity portfolio, you might want to look at lower beta stocks. The real importance of betas is that you can measure the risk you’re taking in a scientific way – and the results might just be surprising.
Once you’ve understood your risk, you can do something about it. That might be holding a large cash cushion against a high risk but potentially high return portfolio. It might be some currency hedging, perhaps using a currency fund or ETF. It might be buying an emerging markets fund. It might be as simple as using a 10% stop loss against your most risky investments, or hedging your biggest position using a short position in options or covered warrants (though that will only work in the short term). But the key to all risk management is quite simple; assess the risks you’re running, and work out whether you are happy to run them, or whether you want to do something about them.