Six ways to reduce risk in your portfolio

Hollywood loves to make movies about risk-takers, from Ferris Bueller’s Day Off to Field of Dreams. We love to watch other people take risks and triumph in the end. In the new movie Moneyball, Brad Pitt stars as the general manager of the Oakland A’s baseball team. He takes a big risk to rev up his ailing team by using computer-generated mathematical analysis to choose players rather than the traditional scouting methods.

Most of us would like to take more risks in life and with our investments, if only they weren’t so darn, well, risky. The following are six types of risk that might be lurking in your portfolio and how you can handle them.

1) Capital risk

This is the big one. Capital risk is the fear of losing your capital — the money you saved up and invested in the first place. For many people, capital risk is daunting enough to prevent them from investing at all. Unfortunately, no risk equals no reward. The riskier the investment, the higher its potential return.

How to handle? Think long term and do your research. If you put money into a retirement fund you won’t touch for 30 years, you will not focus on the daily swings of share prices. Choose prudent, well-managed companies that have a stable history of rewarding their shareholders over time, then stick to your strategy and go to sleep at night.

2) Purchasing power risk

Suppose you have $100 saved, enough to buy five lipsticks. You’re afraid to invest the money and possibly lose it, so you leave it in your deposit account or stick it under your mattress. However, each year, inflation causes lipstick prices to rise. If you pull your $100 out after 15 years, you will only have enough to buy three lipsticks. By not earning anything on your savings, you’ve lost purchasing power.

How to handle? Make sure your savings are earning enough interest or returns to at least keep pace with inflation. In Canada, inflation is typically between 2-3 percent per year, but of course that can change depending on the state of the overall economy.

3) Volatility risk

You know it happens when you’re dieting. If you weigh yourself repeatedly throughout the day, you may be shocked to find that you gained three pounds since this morning and yet by tomorrow morning, you’ve shed five. It’s enough to send a person running for the bag of brownies. It’s the same as investments — daily volatility in market prices is normal.

How to handle? Choose regular intervals to review your portfolio — maybe monthly, quarterly or even annually depending on your investment time horizon. This allows you a more objective view on how the investment performance is trending.

4) Interest-rate risk

If you think bonds are so much safer than stocks, think again. Bonds trade daily just like stocks and the prices fluctuate. Think of it like buying a car. If you buy a certain model this month and then next month the same model is re-issued — except in a cooler British racing green with an iPod dock — the value of your model will go down.

How to handle? With bonds, as with cars and any technology, there will constantly be a newer, faster, cheaper, better thing coming along. In the meantime, if you need one you can only do your best to pick the one that’s right for you at the time and then be happy with it until it’s time to trade it in.

5) Credit risk

If you’ve been following what’s happening in Europe lately, then you know about credit risk. This is the danger that the bond you bought might become worthless if the company or government that issued it ends up defaulting on their debts and goes bankrupt. When credit ratings are low (typically because the issuer already has a dangerous amount of existing debt), the issuer has to pay higher rates to encourage people to buy their bonds.

How to handle? Choose whose bonds you want to buy carefully. Canada is a triple A rated country, so it’s highly unlikely that it will default on its bonds. Italy, in contrast, provides higher yields and higher risk for those daring enough to invest. Traditionally, government bonds were seen as less risky than corporate bonds, but these days it depends on which countries and which companies.

6) Company or industry risk

All too often it happens that a person’s entire investment portfolio is comprised of the shares of the company where they work. They max out their company share purchase plan and don’t give it another thought. Or, someone might own a home, a cottage and have a job at a real estate company and have few other investments. In both cases, these people’s entire investment portfolios are at risk if something happens to the one company or industry in which they are invested.

How to handle? The golden rule of managing risk is to diversify. Get those eggs out of that one basket and spread them across industries, sectors and asset classes. Mutual funds and ETF’s provide an easy way to spread a relatively small investment across a wide range of assets, reducing your reliance on any one company or industry.

The risk / reward balance

As with anything in life, there is no reward without some risk. Finding the right balance is a very personal matter. Ask yourself what you would prefer as a worst case scenario: losing some money in an investment that goes wrong; or, losing out on a profit by staying on the sidelines? By asking yourself this one simple (yet oh-so complex) question, you might just get to the root of how much risk and reward you truly can handle.

GoldenGirlFinance.ca is a free personal finance and education site for women.

Nothing contained herein is intended to provide personalized financial, legal or tax advice. Nothing should be construed as an offer to sell, or a solicitation of an offer to buy a security, a recommendation for any product or service by Golden Girl Finance or any associated third party, or a suggestion regarding the purchase, holding or sale of securities. Before implementing any financial strategy, you should obtain information and advice from your financial, legal and/or tax advisers who are fully aware of your individual circumstances.