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high-net-worth investing

Most wealthy individuals play “active defence,” using specific strategies to limit potential losses and preserve capital – a key element of portfolio outperformance over time.Getty Images/iStockphoto

If there's one thing the long, strange U.S. election taught us, it's this: Nothing is certain.

This strikes me as a particularly important piece of wisdom to keep in mind right now, as we enter a time of increased political and market uncertainty. Despite our best efforts, no one can say what a given company, asset or sector of the economy will do in the future. We can only assess probabilities and position accordingly.

What – if anything – can investors do about this?

Over the years, I've noticed high-net-worth (HNW) investors answer this question differently than those of more modest means. Most wealthy individuals I know are not content to sit back and let their portfolios drop in value. Instead, they play "active defence," using specific strategies to limit potential losses and preserve capital – a key element of portfolio outperformance over time.

In part, HNW investors do this because they recognize they don't have to take unnecessary risks – they've already made their wealth. But there's also a difference in mindset. Generally speaking, HNW individuals have a sense of humility in the face of the future: most have learned through experience that sometimes, the unlikely or unexpected happens. They prefer to be prepared for it (even if there's a cost to that preparation) rather than relying on hope and crossed fingers.

You might think that wealthy individuals use complex strategies to protect wealth. Not true. In fact, many of their strategies can be implemented by investors of all stripes.

Holding cash

Most HNW investors I know hold about 10 per cent of their portfolios in cash (although I wouldn't be surprised if that creeps up in the months ahead). For the most part, their cash is in GICs or T-bills or high-interest savings accounts – HNW investors don't use "exotic" notes or complicated structures in an effort to squeeze out every bit of yield.

Diversification

Most investors have heard the defensive rationale for diversification; I don't have to repeat it here. But in my experience, HNW investors follow it more rigorously than those of more modest means. On the whole, HNW investors are well-diversified by asset, by geographic market, and by investment style. They re-allocate and re-balance regularly.

Why? Because it works.

Stop loss orders

Instead of getting emotionally attached to their positions, they set a stop loss – an order to sell if the value of a holding falls to a certain point. Usually, that's a drop of around 20 per cent.

I've seen many HNW investors use rolling stops to protect gains: As a position gains in value, they reset the stop loss a little higher. This can offer protection in a market that looks "toppy" but is still posting gains.

Options

The HNW investors I know aren't interested in using options for trading or speculation. Instead, they use them to protect large positions. By purchasing puts (the right to sell a given security at a given price for a given period of time), they establish a "floor" price and limit their potential losses.

I've also seen some use options to provide protection against broader, market-wide declines by purchasing puts on a broad-based index exchange-traded fund (ETF). If the market goes down, the value of their options goes up, offsetting any losses.

Alternative assets

Alternatives include hedge funds, managed futures, commodities and certain real estate investments. Some of these get a bad rap for lack of transparency and high fees; many times that criticism is well deserved. That said, most HNW investors still value them as a "safe haven" in times of market turmoil.

The vast majority of HNW investors hold long/short or market neutral hedge funds, which utilize short positions or paired trades to take advantage during volatile markets. Some also hold managed futures funds or commodities because of their low performance correlation to traditional asset classes.

You don't have to be rich to benefit from alternative investments. Hedge funds are now widely available through ETFs and exchange-traded notes. Just make sure to keep the position balanced, up to a maximum of 40 per cent of the portfolio is a good target, but guidance from a professional is advised – and be highly selective about fees.

Thane Stenner is portfolio manager and director of wealth management of StennerZohny Investment Partners+ within Richardson GMP. He is a founding member and chairman emeritus of TIGER 21 Canada and author of True Wealth.