Twenty-Five Ways to Reduce Investment Risk
With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.
- Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
- Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
- Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
- Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
- Avoid explicit leverage; don’t use margin.
- Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
- Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
- Avoid balance sheet complexity; it can be a cover for accounting chicanery.
- Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
- Avoid owning popular companies; they tend to underperform.
- Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
- Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
- Focus on industries that are out of favor, and look for strong players that can withstand market stress.
- Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
- Take something off the table when the markets run, and edge back in when they fall.
- Analyze how any new investment affects your total portfolio.
- Don’t use any investment strategy that you don’t fully understand.
- Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
- Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
- Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
- Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
- When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
- Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
- Size positions inversely to risk levels.
- Finally, think about risk before you need to; make it a positive component of your strategies.
Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.
If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.
