Most people who pull their money from the stock market, or never invest in it at all, do so because of improper risk management, which leads to hasty decisions and significant decreases in their future selves’ quality of life.
In this article, we will teach you how to build a stock portfolio optimized for your particular financial situation, enabling you to take an appropriate amount of market risk, reap the rewards of compound interest and improve your ability to fund your life’s goals.
5 steps to mastering risk management in the stock market
- Understand the concept of risk
- Determine your risk tolerance
- Determine your risk capacity
- Diversify your investments
- Set investment buy and sell strategies
1. Understand the concept of risk
The prevailing definition of risk among professional investors is the potential for permanent loss of capital, whether that be a portion or all of a given investment. While this potential can be minimized, as you’ll learn from this article, it can never be avoided, because new businesses are never guaranteed a pathway to success.
The most common measure of risk is volatility, usually expressed as a percentage representing how far a stock is expected to fluctuate up or down based on history. Here are two examples:
- If we look up cancer research outfit Theralase Technologies (TSXV:TLT) on Stockhouse, we see that the stock’s beta is 1.4. This means that for every percentage point the broader Canadian market moves up or down, Theralase will overshoot or undershoot that move by 40 per cent, making it a moderately volatile stock.
- A more extreme example is jet-maker Bombardier (TSX:BBD.A), which clocks in at a beta of 2.97, meaning investors must be willing to endure a roller coaster ride, at least compared with the broader market, to benefit from a position in the stock.
That said, volatility should be complemented with research into the underlying business’ management, differentiation from competitors, financial performance and industry prospects to offer a more holistic picture of the risk entailed by owning a stock.
To be a successful stock investor, it is also essential to match your portfolio with the risk your psychological makeup allows you to take, known as risk tolerance, and the risk your financial means allow for, known as risk capacity. These foundational steps will ensure that you don’t sell stocks because of expected volatility, optimizing your chances of having enough money to follow through on major life purchases such as a car, a degree or a new home.
2. Determine your risk tolerance
The second step to mastering risk management in the stock market is determining how your psychology matches up to volatility. If you invested in the S&P/TSX Composite Index (the base measurement for beta mentioned in step 1) over the past decade, your investment would have risen or fallen by about 13 per cent per year on average, often exceeding this number by a wide margin.
While whipsaws have surpassed 30 per cent, such as during the COVID-19 pandemic of 2020, and 50 per cent, such as during the dot-com crash in 2000, the index managed a 7.94 per cent annual return over the 50 years spanning Nov. 30, 1971, to Nov. 20, 2021, according to data from Questrade.
If we step back and take a global perspective, a long-term holding period has found similar success, with an investment in the global stock market netting you 5 per cent above inflation per year from 1900 to 2018 with volatility of 17.4 per cent.
Two possible pathways can be followed based on these figures:
- If you’re confident in your ability to understand that short-term losses in stocks are not reasons to sell, but likely buying opportunities, you’re a good candidate for owning stocks and matching up their historical returns with your available capital to cover the cost of your financial goals.
- If the mere sight of a red number is the stuff of nightmares, you should hedge your stock exposure with lower-volatility, lower-returning investments such as bonds and cash until you’re comfortable with the ups and downs of equity ownership.
Regardless of risk tolerance, your behaviour as an investor will be heavily dependent on how you react when your money is in the market. Your success as a stock investor is then directly proportional to your willingness to make adjustments and find an allocation that helps you stay invested for as long as you need to be.
In an ideal world, the risk you’re willing to tolerate will be sufficient for your risk capacity – or the amount of money you can invest – to earn a return that pays for the life you want.
In practice, despite the stock market rewarding fundamentals over sentiment over the long term, you might have to take less risk than is optimal to sleep well at night.
3. Determine your risk capacity
Your risk capacity is the result of subtracting your monthly expenses from your monthly income. This exercise can go only one of two ways:
- If the number is above zero, you have funds to put at risk in stocks and can begin due diligence at your leisure, supposing you’ve saved an emergency fund to cover unexpected expenses and avoid having to sell stocks at a loss. Most investors fall into two broad categories: index investors, who prefer to own the entire stock market, and active investors, who try to pick the stocks best positioned for outsized returns, with the former being the optimal choice in terms of long-term historical returns.
- If the number is below zero, you’re carrying debt, and should ensure that you are able to pay it off in full before investing in the stock market.
The combination of risk tolerance and risk capacity allows you to set expectations about what kind of return you need from stocks to fulfill your financial goals. A good starting point is to assess your goals against the performance of three types of globally invested index ETFs across the risk spectrum. Examples from Vanguard and Blackrock, the two largest asset managers in the world, include:
- Conservative ETFs such as VCNS or XCNS that hold 40 per cent stocks and 60 per cent bonds.
- Balanced ETFs such as VBAL or XBAL that hold 40 per cent bonds and 60 per cent stocks.
- Growth ETFs such as VGRO and XGRO that hold 80 per cent stocks and 20 per cent bonds.
- All-stock ETFs such as VEQT and XEQT that hold 100 per cent stocks.
Let’s take VGRO’s annual return of 7.72 per cent since inception in 2018 as an example. Supposing you invest C$500 per month, the ETF’s return would take you from C$500 to more than C$91,000 over a 10-year period with 11.02 per cent average annual volatility.
This is well above VCNS’s more than C$76,000 and 8.61 per cent volatility, but falls short of VEQT’s more than C$112,000 and 12.38 per cent volatility, demonstrating the trade-offs between conservative and higher-risk investing.
A compound interest calculator will help you experiment with the returns of the ETFs mentioned above and delineate the portfolio you need to live your best life. You can find extensive suites of similar stock and bond funds from Canada’s Big Six Banks, as well as major investment managers such as Fidelity, State Street and PIMCO to consider for a potential allocation.
4. Blend risk tolerance and risk capacity into an appropriately diversified portfolio
Now that you have working ideas about your risk tolerance and risk capacity, and how these translate into a portfolio, we can offer a detailed picture about what that portfolio looks like.
Your stock allocation
For the stock portion of your investments, diversification can be achieved by buying one or several market capitalization-weighted index fund, like those mentioned in step 3, that grants you exposure to companies across the world. Market capitalization is a measure of market value resulting from multiplying a stock price by the number of outstanding shares. The U.S. currently accounts for about 44 per cent of global market capitalization, while Canada commands a small but mighty 3 per cent.
A finer point worth clarifying is that, while all of the ETFs in step 3 are market capitalization-weighted, they hold a more than 20 per cent investment in Canada. This is because they cater to home-country bias, the global phenomenon of over-allocating into your domestic market, even though it hampers portfolio efficiency and ultimately return potential.
Your bond allocation
For the bond portion of your portfolio, diversification calls for a similar geographical strategy, with the addition of credit quality and duration to ensure well-rounded exposure to the asset class. A 50-50 split between a domestic bond index fund such as Vanguard’s VAB and a global one like VGAB is a good starting point.
Investors may also be interested in knowing that, while the S&P Index Versus Active (SPIVA) study has shown that picking stocks underperforms indexing more than 90 per cent of the time, active bond investors with a global focus tend to fare considerably better. This is why Franklin Templeton’s Global Core Bond Fund (TSX:FLGA) is the only active fund suggested in this article.
With a stock and bond portfolio in place tailored to your temperament and financial means, all that’s left to do is to write down a plan about when to buy more of your investments and when to sell them to help you deliver on your life’s ambitions.
5. Set investment buy and sell strategies
When it comes to buying investments, proper risk management requires you to top up your stocks or bonds when the market pushes them below your chosen asset allocation. For example, if you decided on 80 per cent stocks and 20 per cent bonds and your portfolio currently stands at 75-25, you should buy stocks with any new capital at hand until reaching the 80 per cent threshold.
Given that stocks take about one to two years on average to recover from recessions – and you need to hold them for about two decades to give yourself the best chance at a satisfactory return – you should also take advantage of severe downturns and buy shares at depressed prices if you can afford to wait for the market to bounce back.
When it comes to selling investments, you should do so only if one of the following two conditions are met:
- A stock or fund rises above its intrinsic value, i.e. your assessment of what the underlying business is actually worth, compared with what the price indicates.
- You’re interested in making a purchase related to your financial goals, i.e. the reasons you invested in the first place, requiring that you convert investments into cash and bonds. A good rule of thumb is to sell 25 per cent of a stock position at or above intrinsic value on a quarterly basis ending two years before your planned purchase; in this way, you’ll be protected should a recession rear its head. You may hold an even split between bonds and cash until one year prior to the purchase, at which point you should hold only cash to ensure your purchase happens without a hitch.
You are now well-equipped to manage risk and benefit from the stock market’s history of long-term returns. Check out How to invest: A comprehensive guide to growing your money if you need help with putting your money to work.
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