How to Manage Market Risk

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Manage risk by planning how to react quickly to market changes.
Manage risk by planning how to react quickly to market changes. (Image: business charts with us money image by Andrew Brown from Fotolia.com)

If you invest in the market, you can't avoid risk, but you should plan to minimize it. Your plan should have two parts: how to invest using the best practices, and how to react to changes in the market.

Investing

Diversify to protect yourself against specific company risks. Buying several leading stocks instead of one can help you manage market risk because any stock can decline at any time for any reason. Picking leading stocks from several leading sectors will further reduce risk because of the limited correlation between sectors. Diversification can also protect you against specific issuer risk if you invest in individual corporate or municipal bonds.

Use asset allocation wisely. Spreading your capital across different asset classes with limited correlation can reduce your overall portfolio volatility, at least in theory. But globalization has increased the correlation among most assets. For example, if interest rates rise, they will rise worldwide, depressing all bonds. Higher interest rates will also depress all stocks worldwide. Expectation of slower economic growth will, in turn, depress the prices of commodities and private equity. The bottom line: Asset allocation can minimize the pain but won't eliminate it.

Use high quality corporate, municipal and even US Government bonds if you need the money by a certain date, such as a payment for college or a house down payment. Pick bonds that mature in the month in which you will need the money. You won’t earn much, but the money will be there when you need it.

Keep your assets manageable and, if possible, in one place so you can act fast. Spreading your accounts all over the place can paralyze you at decision time.

Reacting to the Market

Follow the market. No one can " time" it with 100 percent accuracy, but staying attuned to major trends will help you reduce or increase your exposure as needed.

Sell at least part of your holdings early on in a correction. Don't try to tough it out fully invested. Every investor has a pain threshold, and once it's reached, long-term strategy goes out the window and raw emotions take over. Markets hit bottom when all those who wanted to sell have done so. But since most investors have similar pain thresholds, if you wait too long to sell, you are likely to sell at the bottom. By raising cash early, you will be able to sit out a correction relatively pain-free and put yourself in position to scoop up bargains when the correction ends.

Stay in cash if your jitters are running high. Advisers scare clients into action by telling them that being in cash will keep them from their goals. That’s true if you are always in cash. But if you are in cash when everyone else is down 20 percent, you are already 20 percent ahead.

Hedge with short Exchange Traded Funds, or Inverse ETFs. A short, or inverse, ETF rises in price when the underlying market or sector that they track goes down. If, in a correction, you reduce your long exposure, raise cash and buy a short ETF with, say, 20 percent of your capital, you will be in much better shape. The market losses become your gains that can offset declines in your long positions.

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References

  • “The All-Season Investor”; Martin J. Pring; 1992
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