Risk versus Returns

This stock trading question comes from Peter H. who asks:

“My main challenge is to minimise the risk of a major loss of capital while still aiming to achieve a rate of return that is typical of the returns on equities rather than the returns on bonds or term deposits.”

There are two drivers of performance; be fully invested when the market rises in a sustained trend, and defend and revert to cash when a market suffers a sustained decline. If we look back to the GFC, most damage was done by doing the opposite to the above, specifically many held during the worst of 2008 and eventually sold out when the pain got too much. Then, in 2009, they were so shell-shocked they couldn’t possibly buy stocks again so missed the big gains on offer that year. So moderating your exposure to the market is certainly a very useful way to minimise risk during bearish environments.

Also, keeping a portfolio diversified helps minimise risk on an individual stock level. Keeping all your eggs in one basket and watching that basket closely will not work when the expected outcome is unknown (read about that lesson here).

I also think an obvious starting place is having a strategy that not only has a positive expectancy, but also one that has been thoroughly backtested to understand what it can and can’t do. Too often people approach the market without any plan whatsoever, or alternately a plan that they have no idea what the outcome will be.

I’m not a believer in using options or CFDs to hedge positions or ‘fix’ a portfolio. If a portfolio or position is doing the wrong thing, then cut it and start fresh. Options and CFDs simply add an extra level of complexity and cost to the investing process.

Bottom line is that simple works – be invested when the market is rising and defend when it starts falling. Success will come from the long term application of that process.