The bull markets in Canadian and U.S. stocks turned eight years old recently. While it's best left to speculators to predict how much longer these bulls can run, a bit of caution can't hurt, either. With that in mind, consider these strategies to reduce risk in your portfolio if markets take a dive.
Know when to walk away
Don't be greedy with your winners, says Diana Orlic, director of wealth management at Orlic Harding Cooke Wealth Management Group with Richardson GMP in Burlington, Ont. She suggests setting a target price to sell high-performing stocks. "This way you don't ride the stock price up on good news and earnings, only to ride it down on any negative pressure or earnings revisions," she says.
It's a strategy that is advisable in any market because it helps prevent hanging on too long to high-fliers that may be poised for a plunge. If you need a reminder of the possible negative outcomes of loving a stock for too long, just remember that Valeant Pharmaceuticals, Research In Motion (now BlackBerry) and Nortel Networks all had excellent runs before crashing and burning up investor capital.
Stop the bleeding
Stop-loss orders automatically sell a security when its price falls to a set level. For instance, assume you own a stock worth $18 purchased for $12 a year ago. You could put in place a stop-loss order to sell if the price falls to $16. This would effectively lock in your gain at $4 per share, and you would avoid incurring more losses if the stock falls further. The downside is the decrease in price might only be temporary.
"In real life, things seldom work out neatly," says Scott Clayton, a senior analyst for TSI Network and associate editor of TSI Dividend Advisor. So while you may have locked in that $4 gain, you might regret it later if the share price then goes on an upward run.
A rebalancing act
When stocks are surging, investors need to rebalance their portfolios regularly so they meet the original mix of stock, bonds and cash required to reach their investment goals, Ms. Orlic says. In doing so, investors crystallize profits on surging assets while scaling back risk in the portfolio at the same time.
Ms. Orlic says the strategy effectively forces investors to sell high and buy low. It also helps reduce volatility in a portfolio because when a soaring asset class falls, the value of underperforming assets often rises.
Look for alternatives
Owning alternative investments – aside from stocks, bonds and cash – can help buoy your portfolio when markets plunge.
Alternative assets, often non-publicly-traded investments, have gained a lot of popularity in recent years because of concerns over ongoing risks in the equity and fixed-income markets, says Peter Kinkaide, a chartered financial analyst with Raintree Financial Solutions in Edmonton. "With equity valuations generally expensive based on most metrics and fixed-income yields low, investors may want to look at taking profits off the table and investing the proceeds in private or alternative investments, which could include real estate, private equity, business lending substitutes and venture capital."
While some of these can be accessed via the stock market using specialty exchange-traded funds (ETFs) or real estate investment trusts (REITs), these investments can still be dragged down during a crash. In contrast, alternative investments are often decorrelated from markets, so even during bearish conditions, they are able to churn out steady income and even rise in value.
Still, these investments are generally long-term plays that cannot easily be sold if you need access to your capital. As well, they usually require a high level of investor acumen to assess their risks and rewards.
If you have a hunch that a particular stock is going to fall in price, you can short sell it. "Short selling is when you borrow stock from a broker and then sell it," says Mr. Clayton. If the stock price falls, you turn a profit by buying the shares back on the open market at the lower price and return them to the owner, he says, adding that the same can be done with ETFs. The risk is that the stock price could increase once you borrow it, and you would be forced to buy back the stock at a higher price than you paid, which obviously would result in a loss.
Put options into play
A less costly and risky choice involves buying a put option, which gives you the right, but not the obligation, to sell a stock you own at set price, Ms. Orlic says. That way, if the share price falls, you can execute the option to sell the stock at the agreed upon higher price. If the share price doesn't fall, you are only out of pocket for the premium paid for the put, which is a fraction of the cost of the underlying stock. "This is considered 'insurance' for your portfolio," she adds.
Another way to defend against a falling market is purchasing an inverse ETF. These investments track an underlying benchmark index, such as the S&P 500, but rather than their unit price falling in value as the index falls, they proportionately increase in price instead.
"Some experts say inverse ETFs can turn a bad day for the markets into a good day for investors," Ms. Orlic says.
Of course, the risk with inverse ETFs is the underlying index does well. As a result, investors need to determine the appropriate amount of capital they want to allocate to an inverse ETF and for how long they want to protect against the possibility of falling markets because ongoing protection can become costly.
Spread the risk around
One of the best ways to reduce risk is to make sure you're not overconcentrated in any one sector or geography, Ms. Orlic says.
Many Canadians' recent experience with the bear market in our energy sector is a painful reminder of the consequences of not paying attention to this threat to their money, she says. "When oil prices fell, it hurt many portfolios in Canada."
Crucial to this strategy is ensuring your portfolio is diversified across many sectors and geographies, which in turn spreads out the risk, because often when one sector or geography is down and out, another is on the upswing.