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Most investors weren't thinking about risk management a month ago, but they are now. With stock markets in decline and headlines accentuating the negative, the focus has quickly shifted from "what's the upside" to "how bad can it get."

Managing risk means different things to different people. To keep it simple, I'm going to look at it through the lens of three types of investors: Those who have a plan and are sticking to it; those who are significantly under-invested or completely out of the market and those who've been enjoying the good times and are carrying more risk than they intended.

Before I address each of these scenarios, it's important to lay down two principles that underpin any risk-management strategy. First, nobody can predict where the market is going in the short to medium term. And second, making dramatic changes to your portfolio at times of market stress – lower prices and higher emotions – is fraught with danger, for to be successful at market timing, you need to get two difficult decisions right – when to get out and when to get back in.

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Right on plan

For investors who have a target asset mix and are running close to it, risk management is simple. Indeed, it's mostly done. You've accepted that long-term returns are made up of good and bad periods, and you've got a blend of securities and funds that give you the best chance of succeeding in the long run.

In light of the recent weakness in stock prices, you'll need to re-balance at some point – the percentage of your portfolio allocated to stocks has gone down while bonds are up. So far, the market hasn't dropped far enough to demand urgent action, but you should be making adjustments if the allocations get more than 2-3 per cent out of line. As my former colleague and renowned money manager Bob Hager always told me, "You never want to go back up with less than you went down with."

Under-invested

Why would cash-heavy investors need to worry about managing risk in a down market? They're in a wonderful position.

Although it may seem counterintuitive, if you're in this situation, you're taking the biggest risk of all. For a portfolio to beat inflation and provide a reasonable income in the future, it needs to have exposure to a combination of return-generating risks – interest rate, credit, equity and liquidity risks. When you're 20 per cent, 30 per cent or 40-per-cent under your equity target, you're rolling the dice with your retirement.

So if you're heavy on GICs and savings accounts, risk management is about taking advantage of lower prices to move back to your target. Current market conditions provide an ideal opportunity to start de-risking your portfolio by buying stocks. At a minimum, you should take a baby step.

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Over-exposed

This is the tough one. If you now realize you're running with too much risk, be it stocks or exotic fixed-income products, it's not an ideal time to redress your situation. You probably want to be buying rather than selling.

The question you have to ask yourself is, can you live with another 10- to 15-per-cent decline, as unpleasant as that may be? If you can, then it's best to ride out this down cycle. Any changes made to your holdings should be done with the goal of maintaining the portfolio's growth (and recovery) potential. Of course, this strategy only works if you hang in there if markets go lower.

If you've hit the wall and are at your downside limit, then some action is necessary. The timing isn't ideal, but the only way to get back to an appropriate asset mix is to sell stocks.

Risk management is not about precision or perfection. You have to accept that some of your moves, whether they're buys or sells, will, in hindsight, be less than ideal. For instance, any buys you make today may be too early, but if Mr. Market finishes his correction in the next week or so, they may prove to be your most timely. Managing portfolio risk is about being prepared for a range of outcomes, not making a market call.

Tom Bradley is president of Steadyhand Investment Funds Inc.

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