How Can I Control The Risk In My Portfolio? Part 3 in Risk Management Explained
As an investor you can now determine where your risks are coming from and track those risks using factor analysis, VAR and stress testing. The next step is to control the risks by making tweaks to your investments to create a portfolio with your desired risk levels.
There are three ways to control risk in a portfolio. You can diversify, buy insurance or put a hedge on the benchmark (or some other factor).
We have already discussed diversifying which simply means buying more than one stock. You can get 95% of the possible benefits of diversification with only about 25 stocks in your portfolio.
Buying insurance can either mean buying a protective put or selling a covered call. Options are beyond the scope of this document. It is enough to know that a protective put allows you to sell the stock to someone at specified price so you don’t lose money if it drops in value. A covered call is trading the upside of potential gains on the stock in return for a premium payment. Again, if you don’t understand these option strategies please seek additional training.
Hedging allows the investor to eliminate or offset risk within a portfolio by betting against something. For example if you shorted the S&P 500 index you would make money if the index dropped. Rerunning the 9/11 Detailed Stress Test again with a hedge of the ProShares UltraShort S&P500 ticker SDS the overall decrease was reduced from -9.33% to -8.41% shown in the figure. The SDS position reveals why there was an overall decrease in loss, because the SDS position increased +27.85%.
In my next post I will wrap up the Risk Management Explained conversation in a conclusion post. See ya in a bit.
