Monday, March 01, 2010

Managing Risk in Volatile Markets

By Rajiv Hargunani

Every one who has been investing in the stock market over the past few years has been taken on a wild ride, up and down. We naturally enjoy the “up” ride more than the “down” ride. Even today, many investors are frightened about investing in the stock market because they neglect to utilize risk management strategies designed for their investments. While no strategy can be guaranteed to be profitable, nor protect against loss, there are ways to help manage risk.

So how does one manage risk in the portfolio? The answer actually is quite simple. It all comes down to understanding what risk means to you. Each one of us has a different tolerance to risk. Younger people & high income earners tend to be more risk taking where as older folks migrate towards risk aversion.

So what does risk really mean? In Finance terms it could be defined as the uncertainty associated with any investment. In other words, risk is the possibility that the actual return of an investment will be different from its expected return.

Here are few ideas that can help you mitigate the risk in your portfolio:

1. Proper Asset Allocation:

Asset Allocation is the process of distributing your assets into different asset classes that may reduce the overall risk in the portfolio. You can broadly define the asset classes as
a. Cash
b. Fixed Income (Treasuries, Domestic & International Bonds)
c. Inflation Protection Securities
d. Precious Metals
e. Commodities and Natural Resources
f. Real Estate
g. Domestic Equities (Large Cap, Small Cap, Mid Cap Stocks)
h. International Equities (Emerging and Developing Countries)

The rationale behind asset allocation is that different assets perform differently over time, where an asset class having a good year helps to offset an asset class not doing as well. Investing in asset classes that are negatively correlated (or less positive) helps in achieving true diversification. The key to helping reduce risk is to determine what percentage of assets to put in a particular asset class. A good financial planner should be able to achieve this keeping in mind your goals, time horizon and risk tolerance. Markets do and will go down from time to time, and at times those downturns will be gut wrenching, but a well planned portfolio should account for that.

2. Reassess your risk tolerance:

The potential return from any investment can generally be linked to the amount of risk the investor is willing to assume. Finding that balance between the return you desire and the risk you can handle has never been easy. What makes this problem even trickier is that your financial goals - and thus your risk tolerance - inevitably change throughout your life. Therefore, the investment that was right for your goals of yesterday may not be so appropriate today.

It is a good idea to review your investments periodically with risk tolerance in mind.

3. Understand What you Own:
The design and formulation of your portfolio is based on your goals, time horizon and risk tolerance. Understand that what may work for your friend, cousin, or co-worker may not work for you because one size does not fit all.

4. KNOW WHEN TO CUT LOSSES:
Many investors do not know when to get out of an investment. If your investment selection is heading south and most likely won’t return to previous form, face the music and consider getting out before your lumps get too big.

5. Opportunity Loss vs. Capital Loss:
The markets are always presenting investors with potential opportunities to invest. I said invest and not speculate. As long as you have the capital, you can participate in the different opportunities that are presented. That’s why point # 4 is important. Preservation of Capital has to be an important goal.

6. Keep Emotion Out:
Don’t check your portfolio every single day. More importantly, don’t adjust it based on what you hear on TV or read in the papers. You are investing for the long haul. The analyst on the television or in the magazine does not know you or your goals. Use them only as a data point in your overall portfolio design.

7. Plan your way:
Just like when you start up a business, you draw up a business plan or when you go on new road trip, you take out your GPS to guide you. Similarly, having a plan for your investments will go a long way in dealing with market volatility. Knowing ahead of time as to what to do, when the markets go up or down, will keep the emotion out and you won’t be second guessing yourself.

8. Do you manage your own money?
If you are managing your own money, read as much as you can from different unbiased sources. Collect as much data as you can. The best thing to do is to write your thoughts and reasons down on paper. That way you can go back and verify if your thesis was correct or not. Always be willing to think outside the prevailing opinion. Your best results could be achieved if you have answers to the “What-if” questions.

9. Be Proactive:
If you have an Advisor or a Planner managing your money, ask them tough questions about what kind of strategies they are implementing to plan your portfolio for market downturns?

For sophisticated investors, I can share in person more advanced strategies of hedging against a market decline. You can call me at (205)939-0100 to set up an appointment.

Rajiv Hargunani is an independent Financial Advisor based in Birmingham, AL working at Raymond James Financial Services. This material was prepared by Rajiv Hargunani, Financial Advisor of Raymond James Financial Services Member FINRA/SIPC - Ash Place 2100 16th Ave S, Suite 1, Birmingham, AL 35205. Rajiv specializes in wealth management with an emphasis on risk management & asset protection for his clients. Rajiv's financial planning philosophy is really very simple: Plan, Communicate & Perform. In addition to working with individuals, Rajiv helps small businesses set up retirement plans such as 401(K), SIMPLE IRAs, SEPs and takes an active role in educating the employees so they can make solid informed retirement planning decisions. He can be reached by phone at (205)939-0100, (205)541-7438 (Cell) or by email at .(JavaScript must be enabled to view this email address).