5 Best Ways to Manage Your Portfolio Risk in 2021

Successful portfolio management comes down to balancing your risks, optimizing your exposure to risk premia, and diversifying enough to weather any number of possible macro events. This, of course, is far from easy. Luckily, there is a number (5 to be exact) of macro strategies you can employ to ensure you’re protecting your downside while allowing your capital to harvest a decent amount of return. These strategies are: 

1. Start with an investment philosophy 
2. Understand your portfolio
3. Diversify against uncertainty
4. Lean toward liquidity
5. Avoid portfolio volatility

Let’s run through this one by one.

Start with an Investment Philosophy

There are endless ways to skin the investing cat. The “best” approach depends on your goals, risk tolerances, and market approach. A retiree who’s looking to protect his nest egg from inflation and large market crashes, shouldn’t be heavenly weighted to speculative growth stocks relative to safer assets. And vice-versa for a young millennial who’s looking to compound his wealth over the long-term and has more stomach for the volatility of his capital base.  Everyone’s starting point when beginning to think about portfolio construction needs to start here. You need to really think about what you want to accomplish with investing and the type of drawdowns you’re willing to stomach along the way. Again, there is no single right now answer. Just the right answer that fits you.

Understand your Portfolio.

Once you determine the above you can then begin to think about weightings and what different assets accomplish. Every investable market should be looked at from a long-term risk-to-return lens. Where its average annual return is measured against its average standard deviation around that return trend (volatility).  Here’s a little snapshot that shows this volatility/return relationship of the big three asset classes over the last 80 years.  Cash returns little to nothing but isn’t volatile. Bonds return a little more than cash and are a little more volatile. And finally, equities have the highest return but also the highest volatility of the three. 

Diversify against uncertainty.

The legendary hedge fund manager, Ray Dalio wrote the following about the importance of diversification.  From my earlier failures, I knew that no matter how confident I was in making anyone bet I could still be wrong — and that proper diversification was the key to reducing risks without reducing returns. If I could build properly diversified (they zigged and zagged in ways that balanced each other out), I could offer clients an overall portfolio return much more consistent and reliable than what they could get elsewhere.  This insight on diversification was foundational to Dalio creating his hedge fund that’s gone on to make more money than nearly any other fund in history. He uses what he calls the “Holy Grail” of portfolio construction, where you diversify with over 15 uncorrelated return streams and balance out your return per unit of risk. That approach is likely too advanced for most but fortunately, there’s a simple way to think about it and arrive at similar results.  The idea behind diversification is that we need to protect ourselves against (1) unexpected outcomes and (2) our own ignorance.  We do this by having an asset mix comprised of a wide range of uncorrelated assets. For example, bonds move inversely to stocks. Emerging market equities tend to move inversely to the US dollar. US Growth stocks have a positive correlation to the US dollar and are inversely correlated to interest rates.  Understanding these relationships, allows you to allocate your portfolio in a diversified manner. This results in a better risk-to-return adjusted portfolio, that will make your capital base more robust to a range of potential market environments. There are a number of widely available free tools to measure these relationships. 

Lean toward Liquidity.

Liquidity is the thing that nobody thinks about until they really need it and by that time it’s gone. It’s the ability to get in and out of your positions. Liquidity varies by asset and throughout market regimes. When there’s a large liquidity shock (say 2008 for example), liquidity dries up and it becomes difficult to exit your position without taking a large loss. The best way to avoid putting yourself in this unenviable position is to strictly invest in markets that are very liquid. You can measure liquidity by looking at its average US dollar share volume traded daily. Your minimum liquidity requirement will vary depending on how large your portfolio is. But, as a simple rule, you should always error on the conservative side and stick to buying things that do a large amount of volume on a regular basis. 

Avoid portfolio volatility.

Compounding, as Einstein said, is the 8th wonder of the world. Positive compounding is what enables you to increasingly grow your wealth over time. The flipside of this, of course, is negative compounding. Where large losses beget more losses. For example, if your portfolio loses 50% in a market crash. You’re going to need to gain 100% to just get back to your starting point. Now, volatility in your portfolio is normal and unavoidable. And if you follow the 4 rules above and abstain from making portfolio decisions based on emotion (fear and greed), then your portfolio will grow over time.  Remember… start with investment philosophy, understand your portfolio, diversify against uncertainty, lean toward liquidity, and avoid outsized portfolio volatility. Follow these five macro strategies and your wealth will be sure to grow over time.  Read Also:  4 Tips To Grow Your Graphic Design Agency In 2021