Learn the basics of portfolio risk management.
There are two major risks to investors' portfolios:
Lack of liquidity
Portfolios should be flexible, varied, and geographically diverse, including a mixture of assets:
Investors can't predict Black Swans but, by offsetting risk and diversifying their portfolios, they may give themselves a better chance of turning such events in to opportunities.
Gauging the ‘fear factor’: The VIX
The VIX volatility index is commonly known as 'the fear index'. It measures risk, and market expectations of near-term volatility derived from the prices paid for put and call options. It does not indicate whether the market will fall, but merely that it will move in one direction or another.
If the VIX is at a low level:
Investors are calm and foresee little that will unsettle markets
It can be a good time to take out cheap portfolio protection
If the VIX is at a high level:
Investors are anxious
about a risk event
Portfolio protection can become expensive
Identifying when markets are ‘risk on’ and ‘risk off’
'Risk on' or 'risk off' are terms which describe the mood of the market over a particular time period.
When markets are 'risk on':
- Investors are confident
- Media is bullish
- The market/economy might be in bull/full recovery mode
- Risk assets such as equities thrive
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When markets are 'risk off':
- Investors lack confidence
- Media is pessimistic
- The market/economy might be in the bear/full recession phase
- 'Safe haven' assets such as gold and the dollar thrive
Investors may hold risk assets in their portfolio while also taking out protection against potential losses: this is usually in the form of options. For instance, you might think a market will rise over the long term, so you buy a basket of assets to reflect this view. Short term, however, there could be some potential volatility, so you protect your position by taking out an option to sell the assets at an agreed price, which provides you with some protection in case the market suddenly falls.
- Diversifies portfolio
- Spreads risk
- Margin on options can be cheap
- Protection can be expensive if you take it out at the wrong time
Stop loss orders
A stop loss order is an instruction to sell an asset when it reaches a certain level below its current market price. This acts as a safeguard against heavy losses.
- Provides downside protection in volatile markets
- Can be adjusted depending on how much you are willing to risk losing
- Needs to be manually managed
- No control over it being triggered in a flash crash
Algorithmic trading or automated trading takes the sentiment out of dealing and allows traders to specify sets of rules according to which a computer will buy and sell assets.
- Reacts faster than a human
- Takes the emotion out trading
- Greater consistency and discipline as it works to rules
- Lack of human control
- Risk of mechanical failure
- Too many rules and data