Within the financial universe, investment risk has been most commonly defined as “the probability of a permanent loss of capital.”
Investment risk is also commonly referred to as volatility. Most investors probably want at least a consistent annual return. To keep everything relative, this means you do not want your annual returns to fluctuate much.
An easier way to think about risk is to plan for a 50% drop in the value of your investment portfolio during a market crash. This does not apply to fixed income investments such as a GIC.
Most importantly… when we talk about investment risk, you should never invest money that you will need in the next few years. The best case scenario is to not access your investment portfolio until you’ve decided to retire.
If you simply let your investment portfolio work for you over time, you will be able to manage your investment risk and also benefit from a few things:
1) You vs. your emotions
You will not be tempted to make irrational decisions based on your emotions such as selling your investments in weak markets due to fear, possibly resulting in a capital loss.
If you don’t need the money, there is no reason for you to sell at a loss except if your investment thesis has changed. Economic cycles will always occur, but if the investment thesis of a stock has changed resulting you to doubt the potential of your investment, you should sell regardless of whether the financial markets are strong or weak.
2) Be greedy when others are fearful
Great times are exactly that… great! But they don’t always last. As a smart investor, you will always have a little cash in your investment portfolio or plan to add some cash as well. If you are collecting dividends, let them stockpile as the markets are falling.
When the markets fall, they will not complete the entire move over night which means you have time to plan. By planning to have cash available, you will be able to buy the same stocks in your portfolio for a significantly lower cost allowing you to reduce your average cost base.
When it comes to investing, market crashes are a blessing for the rational and disciplined investor!
3) Peace of mind with dividends
Buy income and dividend paying ETF’s (Exchange Traded Funds) and good solid companies (blue chip stocks) that pay dividends.
Why? You will continue to earn your dividends in weak market conditions as well. The dividend payout might change to reflect the economic conditions, but you will still have a dividend!
4) Hedge your portfolio
One of the easiest ways to manage your investment risk when markets begin to crash is to hedge your portfolio with an inverse ETF (sometimes referred to as a “bear” ETF).
In a nutshell, you will make money as the markets continue to drop.
An example of an inverse ETF is the Horizons BetaPro S&P/TSX 60™ Bear Plus ETF… HXD.
Note: Do your research before choosing an inverse ETF and deciding how much to invest. Similar to inverse ETF’s, another choice is to use put options on popular market index funds such as SPY.
Another important way to reduce investment risk is to diversify among various asset classes (commodities, utilities, real estate, CPG manufacturers, retailers, etc…). Diversification will balance your investment portfolio with the objective of some asset classes outperforming other assets at different points in time.