What are the best ways to mitigate risk in an investment?
Best Answer
699 points
7million7years answered one year ago …
Three obvious ways:
1. Knowledge/education so that you select the right investment in the first place, then
2. Having a buffer and/or margin of safety in case things go temporarily sour, then
3. Having an exit plan in case things go permanently sour.
Let's have a look at a stock-related example:
You purchase AAPL at $185 believing - having done some considerable research (e.g. will the 'Chiniphone' come to fruition?) that over the next 5 years it is a $400 stock. You discount the $400 to today's price and can see that it should be trading at (say, this is only an example) at $195 today. Does the slight discount provide a sufficient margin of safety? Probably not, but you decide that you have enough cash reserves that you can hold th stock through a slight downturn so you buy anyway. Finally, at what point do you bail out of a falling Aple stock? $160? $120 $80?
How about a real-estate example:
You do you research and find a somewhat under-rented, poorly maintained quadraplex. You buy it for slightly under current market value, but you also have a margin of safety in that you know that you can rehab quite cheaply (purely cosmetic ... a thorough inspection showed no structural problems, mold, termites, or envirnmental issues).
You could finance with a 25% deposit, but you decide to put in only 15% to (a) increase your leverage slightly (and, you fix the mortgage for 7 years). You hold a the remaining 10% of the deposit that you could have applied as a buffer against cost over-runs in the rehab process and against longer-than-expected time to refill with tenants.
In both cases, risk was managed by buying at a discount to what you believe to be current 'fair market value' (with even more value to be added fairly cheaply in the RE example), and you kept a buffer that allowed you to ride through short-term 'issues' on the way to the inevitable positive long-term future!
Answers
2775 points
Oldman answered one year ago …
For taxable accounts, one could use options, collars, straddles, strangles and calls, shorts, puts,
etc.
For tax- sheltered accounts, where you can't pledge assets or take loans, one should consider spreading the risk among a diversified group of assets: it's portfolio risk that' important.
One way to do this is to consider the size of the position relative to the portfolio's value: a single security (isssue, bond) really should not be more than 4% of a growing portfolio (where additional deposits are being made each year.)
A trailing stop of 15% is appropriate, and a stop-loss of 25% of the initial purchase price means that even if the security's price may go down to zero, your portfolio will only have a 1% total loss...if you follow the stop-loss discipline.
Larger positons may be taken in diversified ETF's, ETN's, Mutual Funds and Closed-End Funds that sell at a discount to their NAV...but shouldn't exceed a 10% portion of the portfolio. For a $500K IRA/403(b)401K example, no one fund or sector should be more than $50K; no single security should be more than $20,000. If they grow more than the whole portfolio's return, then "milk" the winners, and add some to the under-performers...if it still makes sense to do so, based upon a total portfolio view.
When you have a time-horizon of > 25 yrars, it does pay to have securities' dividends from "Utilities, Blue Chips, REITs", etc, reinvested...and after 25 years, the reinvested dividends will be more than the original purchase price and provide a great income stream...but because of the taxation changes, this may not "pay" for taxable accounts.
Finally, avoid buying high (Mutual Funds give Cap Gains and Divs when they've done well, and it's better in a taxable account to direct these to a core cash account and you buy more when the prices are cheaper...about every 4-6 years...instead of buying at increasing NAV costs, since sideways and bull markets last much longer than bear or correction markets). This can also be done in an IRA, but usually isn't allowed in 403b and 401K accounts, where divs & CG are automatically reinvested.
This approach, called "dollar-value-averaging) is vastly superior to "dollar cost averaging".
If you are retired, or no longer able to put in new money into sheltered accounts, seek those securities that pay dividends in excess of inflation + taxes..which isn't easy, because you are looking for an income stream of 7-8%, without gimmicks of "return-of-capital". But there are some stocks that do this (maritime bulk shippers, e.g.), CanRoys, that have a secure development base and aren't converted to limited partnerships, and some ADR's. In these accounts, try to reduce position sizes to < 2% of the account's value, because short-term losses are permanent.
In non-sheltered accounts, there are Royalty-trusts, short-term business loans and contracts, MLP's and PTP's that throw off tax deductions, return of capital (converting income streams tocap gains), etc.
None of this "reduces" risk (opportunity), but it means that some components will be winners to offset small losses.
Finally, if you are retired, consider the stream of income from Social Security, Pensions and Fixed annuities, as the bond equivalent of a portfolio...If you add the yearly income from all these sources, and multiply by 25 (approximate discount of <4%)...this is the net present value of the stream of income a if it were "Bonds" in your entire portfolio...a retiree who has a $25K income (pretax) from social securityand/or/pension/and or fixed annuity has an approximate $625K "Bond" component, so further investment in bonds is usually not a terrific idea, unless one contemplates a very short life..
