Managing risk is a vital part of being a successful investor. Lowering risk is easy to do, but the tricky part is being able to lowering your risk without giving up all of your returns.
I am a big advocate of investing with the least amount of risk possible, but if you aren’t getting a return on your investment, you’re not doing yourself any favors. You could easily stuff all your money under your bed and have zero risk of losing money, but that would do nothing to benefit you down the road. You have to have a good balance of low risk and returns to be successful.
There is any number of ways to minimize risk while still being positioned to get returns. I’ve highlighted three of the most-common ones below.
Diversity is the key to any investing approach. The logic behind diversifying is simple… you don’t want to put all your eggs in one basket. There are many ways to diversify your portfolio without having to sacrifice returns. Some people prefer to use index ETFs or mutual funds to diversify their portfolio. Investors who are just starting out often fail to diversify because they have such a limited amount of capital at their disposal. They begin investing by adding a stock here and there and plan to eventually work their way to a diversified portfolio. You can always diversify with limited funds by looking at index or other mutual funds. Not only do these investments allow you to diversify over a basket of stocks with limited capital, but also takes the work out of your hands. In the case of index funds, you will still get returns (or losses) equal to the broad market, and in the case of mutual funds you have investment professionals constantly evaluating the market and re-shuffling your holdings. From beginning to expert traders, diversity is the key to long-term market success.
2. Covered Calls
Options can be a very powerful tool to reducing your risk. One strategy that I really enjoy is the use of covered calls. A covered call is selling a call against stock that you have in your portfolio. This strategy is best used when an investor has a neutral to slightly bullish outlook on the equity, or market in general. By selling calls against long positions, you are able to effectively lower the cost basis on your long holding. This strategy most often involves selling an out-of-the-money call, so unless the stock rises enough to cross through the strike price, you are still left with your stock at expiration as well as the credit you made from the sold call. The credit from selling the call reduces your risk by lowering your cost basis, but the downside is that your are possibly limiting your potential upside. Should the stock make a strong move higher, your return is capped at the expiration price, plus the credit on the call you sold. You should not use this strategy if you are extremely bullish on the underlying security, but in other situations it can be a powerful tool to add to your arsenal.
3. Buying puts for portfolio insurance
We insure just about everything in our lives. We have health insurance, car insurance… why not portfolio insurance? It makes sense that when you invest your money in the stock market, it would be great if you could somehow take out an insurance policy out on that money just in case things go wrong. There is a way you can do this, and it involves buying puts against your long positions. Just like you hope to never have to take advantage of your health or car insurance, you hope that you never have to take advantage of your portfolio insurance, but sometimes things go wrong, and puts can help.
Assume you own 100 shares of Apple (AAPL) stock. You believe that the stock is going to continue its recent climb through the remainder of the year, but you are a bit wary as a result of the ups and downs it has encountered over the last trading year. You could simply sell your stock and book whatever gain or loss you have at the current time, or you could buy a put and hold onto your shares. In an ideal world, the stock will keep going up and your puts will expire worthless. If things go badly, and Apple stock plummets you locked in a chance to sell your shares at the strike price of your sold put, regardless of how far the stock actually falls.
Insurance is a something we all hate to spend money on, until we need it. Don’t overlook the risk reduction you can enjoy by buying puts against your long-term holdings.