By Matt Redshaw
Ben Graham, mentor of legendary investor Warren Buffett, noted that successful investing is not so much about the management of returns, but the management of risks.
We believe this is absolutely the case. Consider the following scenarios:
• If your portfolio drops by 10%, you need an 11% return to break even again
• If your portfolio drops by 25%, you need a 33% return to break even again
• If your portfolio drops by 50%, you need a 100% return to break even again
Having the ability to “play defense” in a portfolio helps preserve capital so you can recover faster from a drawdown. You won’t need near as big of a gain to get back to and beyond where you were before the downturn (think of the return required if your portfolio falls by 25% or 50%). Good risk management translates into better performance over time with less variability.
So how does one go about playing “defense” in their portfolio?
There are several ways to manage risk. Here are some of the ways we do it:
1. Have a System
We use a system that looks at the strength of the equity market (stocks) against other assets classes, including cash, bonds and commodities. When the relative strength of equities is strong, we have a green indicator – this means we will stay invested. When equities show signs of weakening, but haven’t shown definitive weakness relative to other assets, we go into “hold” mode – we sell individual stocks when our process signals a sell, but we will not add any new positions. This increases our cash position, making the portfolio more defensive in these times. When equities are showing clear weakness against other assets, our system has a red indicator and we will sell all equities. It sounds extreme, but it has helped avoid some big drops in the market.
2. Buy “Insurance” on the Portfolio
Another way to protect a portfolio is to use options, such as protective puts. One of the strategies in our low volatility equity portfolio relies heavily on options to minimize volatility and reduce downside risk. We like how this approach places somewhat of a “floor” beneath the portfolio, in essence a worst case scenario if the market were to drop significantly.
3. Proper Asset Allocation
One of the greatest errors investors make is over-allocating to, and staying invested in, risky assets. I often see the investment statements of individuals who have very concentrated portfolios that have not been managed and are sitting on large losses. You can tell the objective was to place big bets and get lucky. If you do concentrate you portfolio, be sure that it is actively managed to minimize losses. It is important to have a portfolio that is appropriate for your age, stage and goals. We strongly believe if your portfolio is structured suitably, you should have some safer assets in the portfolio, which will provide a cushion in down markets.
For more information on how to protect your portfolio, or to ask any questions, drop our team an email at email@example.com.