How to Sleep at Night While the Sky is Falling:

On any given day there is a plethora of news and opinions telling you that the markets are doomed and investors should head for the hills. Between Europe, talk of a housing bubble in Canada that is ready to burst and slow growth around the world it is hard to believe that people aren’t waking up with cold sweats from investment related nightmares! Fortunately, there are a few simple strategies that can be used that should help you sleep like a baby once again.

First off, if you immediately worry about your investment portfolio after reading the daily negative news headlines, you may very well be overexposed to equities. Ask yourself or ask an advisor about how much risk you are comfortable with taking on and if you have too much equity exposure relative to your level of comfort. Once you are comfortable with this, three simple tools can be used to help manage the risks inherent with these investments:

• Stop-Loss order
• Protective puts
• Re-positioning to low beta investments 

There is nothing magical or exciting about a stop-loss order but it is a tool that is likely underutilized. A stop-loss automatically sells an investment once the specified price is reached. Determine what size of a loss (10%, 15%, etc.) you are willing to incur on a stock and set the stop order at that price. This allows you to sell a ‘tanking’ investment without being at your computer and also takes the emotional factor out of the decision. This tool can also be used to lock in gains while allowing your investment to continue its rise in price. Be aware of the volatility of the investment you are looking at and allow for an appropriate ‘cushion’ that prevents the stock from being sold simply due to its regular day to day movements. Stop-losses are not to be used on small cap illiquid stocks, and are certainly not for everyone. The Flash Crash of 2010 hurt a lot of investors who had stop-losses in place.

Protective puts (owning a put option on the same investment that you own shares in) are a great way to protect against potential losses, particularly if the stock in question is approaching a questionable earnings release or potential negative event. Compared to stop-loss orders, this strategy is more complicated and does cost money but value is gained through having the option to sell the investment as opposed to flat out selling it with a stop-loss order. Be careful and make sure that the costs of the puts are not eroding your profits. Further, it is important to ensure that you have an understanding of options before carrying out this strategy. If options are something you are uncomfortable with, it is likely better to stick to stop-loss orders. 

One last tool that can be used to limit market risk is simply being aware of the betas of your individual investments. If you find that your portfolio consists of many high beta investments (move to a greater degree than the overall market movements) and that you cringe due to the daily movements of these investments relative to the market, there could be value in simply re-allocating some of this capital to low beta stocks. This will allow for smoother day to day changes barring some company-specific event.

We probably should not wrap this discussion up without noting the importance of diversification in a portfolio and its ability to enhance returns while reducing risks. This is likely the easiest and most effective risk management tool of all. There are many headwinds out there, some legitimate and some not, that can create times of uncertainty and sway an investor’s confidence. After being able to get a good night’s sleep again, you may feel that taking the time to manage risks and mitigate losses was the best investment you ever made.