Equity investing is typically a long – term venture that involves investing in relatively risky assets. This is as a result of the fact that stock prices are especially volatile. Some investors also participate in day trading. Whichever the case, anyone would like to protect themselves from risk in their stock portfolio. There are two concepts that work in tandem in this respect: risk mitigation as well as loss mitigation. The former deals with adding assets that are generally less risky to your portfolio in order to reduce the overall risk of your portfolio. The latter deals with minimize the losses sustained from one’s portfolio. However, the same steps are taken for the two principles in such a manner that by trying to mitigate losses, one must necessarily be mitigating risk in their portfolio.
The underlying principles in protecting your portfolio lies in how your portfolio is laid out. In its simplest form, one could either change the weighting of assets within the portfolio or change the assets within the portfolio. Note that this methodology applies to local investors as well as investors carrying out international share trading.
Investing in stocks with low volatility
Markets are known to have some select stocks which have stable prices that never change but offer large cash dividends. This is typical for companies that are already in the mature stage and thus have little need for cash to invest within the business; they offer large constant dividends to maintain investors coupled with a constant relatively small annual growth. The usefulness of these stocks is in their behaviour in relation to the market: – they are weakly proportional to the market index. What this means is that when the market is doing well then, they’re doing well also, just not to the same degree. Thus, when the market goes up 10% then these stocks may go up by 2 – 4%. This may not look so promising at first, but it’s how these stocks react in a downturn that matters in the context of loss mitigation. It follows that in the case of a market downturn of, say, 10%, these stocks will go down by a much lower margin, perhaps 3%.
This may not seem quite as promising, since your portfolio is going down, nonetheless. However, in real sense you are actually beating the market since your portfolio will outperform the market returns. Furthermore, since it is assumed your portfolio (for long term investors) has been growing quite a bit, the impact of a 2% loss in some portion of your portfolio will not be as bad a blow.
Investing in derivatives
Derivatives are financial assets that derive their value from some underlying factor; in the case of equity derivatives, the underlying factor would be stocks. Derivative instruments are primary risk mitigating tools (in particular airlines that invest in oil futures) in firms. The main derivative contracts that are relevant for investors would be options and futures.
Options are perhaps the most popular derivatives contract; options grant their holder the right but not an obligation to buy or sell an underlying asset depending on the price. There are two types of options: call options and put options. Call options give the right, but not an obligation, for an investor to buy an underlying asset at a specific price. Put options are much the same, except that they grant the right to sell the underlying asset at a specific price.
The best strategy here would be to buy a put option. Say, for example, a company’s stock is rising quickly and is trading at 50$. However, market conditions as well as other factors (such as the current US – China trade war) convince you that the price will decline. You could set a strike price of 53$ for your put option. Consequently, when the price falls to 40$ you can sell the shares to mitigate loss.