Friday, May 21, 2010

How to lower the risk in your portfolio!

Risk ManagementImage by Cold Cut via Flickr

As soon as you start trading stock and build up your own stock market portfolio, you will recognize that there are several factors which influence the risk of your portfolio.

If we look at the previous trading weeks, we saw a lot of ups and downs even within one trading day. The worst time came as the US stock market got it's flash crash two weeks ago. There several of the Blue chips (biggest stock market companies) lost up to 46% of its value within 30 minutes. But most of them recovered throughout the trading session and closed the day with a much smaller percentage loss (e.g. Procter & Gamble, McDonalds).

In case you have been invested in these companies, you would probably have "lost" them when you set a stop-loss limit to secure your existing gains or to avoid a bigger loss from a further decline of your stocks.

Setting a stop-loss limit is always a good choice but it doesn't lower the risk of your portfolio. It just helps you like i wrote in the last paragraph to cash in some of the existing gains or to stop losing more money.

Lowering the risk of your portfolio can be accomplished by

Investing less than 5% in a specific stock or even only in a specific sector

The reason:
If you invest your money in similar companies of the same sector it's most likely that one bad earning report or a slump in that sector will hurt the price of every stock in this sector.
  • Dell can be influenced by AMD or Intel's earning report in case the sale of CPUs and internal graphic cards show a decline in their sales.

  • Nokia can be influenced by Motorola, Samsung or SonyEricsson's sale reports and vice versa.

  • Different sectors move differently during a stock market plunge if you look at gold mining, car makers, technology or pharma companies.
Taking long and short positions of stocks

Long positions are good for the strongest companies in the strongest sectors and short positions should be taken for weak companies in actual weak sectors. If we look at two sectors in the last weeks you could see that the Gold mining sector has been strong but the banking sector has been weak (both are related to the Greek debt crisis).

Diversify and enrich your portfolio with currencies and commodities

Commodities and currencies will reduce the risk and the volatility of your portfolio and you can use currencies for hedging purposes, too (in case your own currency gets weaker against the $, you will gain not only the interests if you buy bonds but a monetary gain due to the better exchange rate). These trades are only for experienced traders, you really should have a certain knowledge of the circumstances for Forex, currency and commodity trading.

Adjusting your Stop-Loss limits from time to time

By adjusting your stop-loss limits you will have more of your gains left, in case a plunge happens. This money can be invested in new and better opportunities or invested in the same stock for a lower price. Sitting out a plunge can make you more nervous and it most of the times you definitely loose more money than by setting a stop-loss limit.

What are your methods of reducing the risks of your portfolio?
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