Equity risk is equity risk. You cannot truly reduce it, but you can mitigate the effect of a particular equity’s risk on your portfolio. Equities are by definition risky. This is because they are volatile, they can lose 50% of their value in space of a few minutes when stock markets open.
They are also lower down the chain when it comes to insolvency. In particular they rank below different forms of bonds. There will also be preference shares to account for. In short your ordinary equity shareholder is taking all the risk, and not always getting all the return first.
Basic risk management practices
How International stocks can help
Although supersize profits from megatrends may sound appealing, taking supersize equity risk is not sensible. Therefore, taking a position size of 3-5% of your total portfolio is optimum. It achieves a good balance between profit and reducing equity risk. Hot Stocks are appealing but are also among the most volatile stocks.
Remember, equities are just as liable to go up as well as down!
As a rule, you should take smaller positions (3%) in smaller companies, and larger positions in more established ‘stronger’ companies. Larger than 5% and the prospective loss is painful, smaller than 2/3% and the return is not worth the risk. Indeed with small positions, you will end up with so many stocks you will not be able to keep proper tabs on all of them.
Although holding a minimum of 20-30 stocks will give you a good level of diversification, this is useless if they are all exposed to the same downside risk. For example, if you buy 25 different oil companies and the oil price drops 30%. The entire stock portfolio is at risk of losing a substantial amount of value. Be aware that although a bank may be considered in the financial sector, it may be heavily exposed through lending to oil companies. This happened to Standard Chartered in the 2010-20 decade, leaving its share price depressed.
Buying a couple of stocks in different sectors which are uncorrelated, would be a way of reducing equity risk to a particular sector. It is generally a good idea to hold 5 sectors minimum, and not exposed yourself to more than 30% of your portfolio to one sector (Even if technology is seen as the way forward!). Although this does not protect you against systematic risk, you may find one sector does not suffer as much as another.
Many will know that the FTSE100 brings together the largest companies in the UK. Fewer will be aware of it’s UK focused little brother: the FTSE250, which groups together the next largest 250 companies. FTSE100 companies are usually international in their earnings and often report in US dollars, which makes them (and the FTSE100) attractive when Sterling loses value.
Exposure to different markets is a form of diversification.
On the other hand, if the UK economy is performing well, UK focused companies are in demand. These are usually found on the FTSE250. As international investors buy sterling to invest in UK focused companies, you will see FTSE100 companies who report in dollars (think HSBC and Astrazeneca) lose value as investors price in negative Forex costs. Sometimes the undervalued pound will give you opportunities which you had not though about.
We live in such an interconnected world that foreign portfolio investment has become easier than it was. Although investing in US shares means more form filling (you have to fill out a W8BEN form), it also can spread your equity risk. Chinese stocks are increasingly part of investors portfolios.
Imagine there is an election result in Britain which is not seen as business friendly. This would likely create some weakness in the main UK markets. If on the other hand you held European or US shares, these would not be impacted by this election result. Sometimes you can get companies which offer you similar qualities. Most UK investors wanting exposure to oil will do so through BP and Shell.
You could buy Total listed in France. Total is major oil and gas producer which pays a similar yield but is listed in Euros. There are disadvantages, as dividends on French stocks are taxed at a higher rate at source than UK listed-ones.
Diversifying equity risk has never been so easy as it is today. Being aware of the market risk premium can only help you better manage your risk. Exposing yourself to Euros and Dollars should not feel foreign when you read about Addidas and Amazon et all on a daily basis. But be careful of the small print!
If you are buying foreign stocks in your trading account, check the foreign exchange cost. It is usually cheaper to exchange currencies away from the broker and then sending it in (though make sure you check they can receive foreign currencies!). Above all do not ignore the basics, such as position sizes, diversifying across sectors and giving yourself a margin of safety.