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How to Manage Your Risk in These Volatile Markets
Daily Gains Letter publishes daily updates on personal finance, investment strategies and financial planning related topics.
During the financial crisis, investors saving for retirement were punished for staying in the stock markets. The key stock indices plummeted and took many investors’ wealth.
After seeing the crash taking a heavy toll on their portfolios, investors moved into safer asset classes. They rushed to bonds, gold, and gold miners because they thought that’s where the value was—and where they could make some of their lost savings back.
Things are different now. If investors are still tied to those asset classes, chances are they are feeling a pinch. Gold prices are down significantly from their peaks and bond prices appear to be in a freefall. Since the beginning of the year, gold has fallen nearly 30% in value, and bond yields—those of 30-year U.S. bonds—have soared more than 20%.
Sadly, even with all the financial innovation, there isn’t an investment instrument that protects an investor’s portfolio completely from market fluctuations. However, investors can minimize their downside risks significantly by managing their risk properly.
Managing risk may sound like an easy concept at first, but it’s far from it. It ultimately consists of three steps and requires a significant amount of research. The three risk-management steps are risk identification, risk evaluation, and risk reduction.
Risk Identification: This is the most important part in risk management. Investors need to find what kind of risks will affect their portfolio. For example, imagine a person heavily invested in one sector; even if he or she is diversified across different companies, troubles can take a chunk out of their portfolio. Take gold as it stands now: even if investors bought different gold miners when gold prices were trading at their highs, chances are that they are in a loss now. Investors saving for retirement need to look at what their risk exposure is and what kind of events can escalate it.
Risk Evaluation: If an investor owns gold miners that take gold from the ground at a cost of, say, $1,250 an ounce, then if gold prices decline below the costs, it will cause the company’s stock prices to go lower. Investors need to evaluate how much their portfolio may decline if gold prices start to crumble. If they own bonds, they need to evaluate how much of a loss their portfolio can take if bond prices go down 10% lower from their current level.
Risk Reduction: Keeping up with the gold-heavy portfolio, one way investors can manage their downside is by exposing their portfolio to different sectors, should they see a major event occurring in a sector they are already heavily invested in. For example, if they believe what’s happening is just a short-term fluctuation and the overall trends will continue, then they can use a covered call option strategy and reduce the losses their portfolio may suffer. (For more on covered call, investors can read this.)
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Source: http://www.dailygainsletter.com/investment-strategy/how-to-manage-your-risk-in-these-volatile-markets/1175/
