Most investors know the age-old saying that with great risk comes great reward. But in the stock market, excessive risk can end in painful losses. Managing the biggest risks with a balanced, well-diversified portfolio can deliver more consistent returns, and, crucially, help you sleep at night.
When it comes to investing your own money – and potentially losing it – there are uncertainties at every turn. It could be a market collapse, a badly chosen stock or a poor decision made in haste, but the risk of getting things wrong can be managed.
With so many variables at play, Ben Hobson, markets editor at investing platform Stockopedia.com, shares his insights on how to evaluate risk and manage it for better returns.
Understanding risk
Warren Buffett, one of the world’s richest investors, describes risk in simple terms. For him, it’s all about the chance of permanently losing capital. Or, to a lesser extent, just not making a good enough return on an investment that he’s made.
Whether you’re a billionaire or new to the stock market (or somewhere in between), Buffett’s words ring true. The nuts and bolts of risk are really about the chances of losing money. And never is that peril higher than when markets become bullish and investor exuberance gets carried away.
We saw an interesting example of this recently involving the US company GameStop, which saw its share price soar and then collapse. A battle of wills between rebellious traders on Reddit and hedge funds traders on Wall Street, probably caught out many naïve investors. A lot of them will now be wondering how and why they lost so much money.
These kinds of events – and the fear of the damage that bad risks can do – is the reason why academics have spent years figuring out how to measure risk. When you hear about risk today, it’s often couched in terms like volatility and correlation. These concepts don’t define what risk is, but they can be useful. They can help you think about how an individual share tends to move around its average price over time, and how different shares tend to move in relation to one another.
These ideas are important because they can guide you on how a share might impact your portfolio. Mixing and matching different types of shares can then help to achieve some balance across your holdings. Add to that other factors like personal risk appetite, your investing timescale, income, goals and different investment allocation and it’s possible to construct a picture of what a dependable stock market portfolio might include.
How to limit risk and make your money work harder
Diversifying a portfolio is one way of making money work harder while cushioning the impact of risk and it can be tackled in different ways. It might mean mixing small, mid and large-cap stocks. After all, small, fast-growing companies can produce stunning profits in buoyant conditions, but smaller firms also carry more idiosyncratic risk, which can make them vulnerable. Larger companies can be better at fending off the impact of market shocks, but their growth rates tend not to be that high.
You can also spread risk by investing across so-called ‘super sectors‘: Cyclicals, Defensives and Sensitives. Cyclical sectors are generally more attuned to macro trends and the health of the economy and consumer confidence. By contrast, Defensives sell goods that we buy in good times and bad, they include drug companies and utility groups. In between are the Sensitives, which move with the economy but not as much as Cyclicals do.
Another way of thinking about diversification is to consider buying into foreign markets. The London Stock Exchange only accounts for around eight percent of global stocks. And while the FTSE 350 does have some natural foreign exposure, a truly diversified world portfolio would theoretically include more than 90 percent in foreign holdings.
A fourth diversification option is to hold stocks with different levels of historic volatility. Periods of high and low price volatility are cyclical. In calm conditions it’s the higher volatility stocks that catch the eye of investors. Yet research shows that it’s the cheaper, less volatile stocks that actually often outperform everything else over time.
Many investors watching recent headlines will have been bewildered by what they saw. It was a snapshot of behaviour that really only happens when confidence and willingness to invest with little care about risk, is sky high.
At a time when the economic conditions remain so uncertain, risk management with the help of diversification can offer some protection – and help you sleep at night – when others in the market are losing their heads.
Disclaimer: Investing money carries risk, do so at your own risk and we advise people to never invest more money than they can afford to lose and to seek professional advice before doing so.
