The risk of a portfolio is always lower than the sum of the risks of its individual parts. You need not only to look at the risk of adding the security but also its ability to reduce overall risks. In this article, we’ll discuss the ways in which you can use risky assets to reduce the overall risk of your portfolio.
Hedging Methods
Shorting a stock is almost always considered as a risky strategy. At best, there’s a chance that you can make a hundred percent on the position if the stock slips to zero. Theoretically, the losses are unlimited if the stock happens to continue to rise.
However, if done properly, you can lower your risk instead of increasing it. For instance, if you are holding a position in a stock that you cannot yet sell, shorting the same stock with the same amount effectively lets you sell the position and lower your risk on the stock to zero.
In a similar manner, you can lower your risk on a portfolio of stocks by buying the appropriate leveraged inverse ETF. A 100 percent hedge will protect you from risk, but it will also reduce your exposure to any upside.
Buying Options
A put option is a risky investment that provides you the right to sell a stock or an index at a specific price at a specific time. Buying a put option is a bearish strategy since you are essentially betting that the stock or the broader market will go down.
You can make money on the decline and the most that you can lose is the price that you paid for the option. The leverage of an option makes it a risky investment.
On the other hand, if you pair the put option with a stock that you own, you can give yourself some protection against a lower stock price.
Hedging limits your risks as well as your upside, but buying a put option still offers you with unlimited upside. This is the reason why this method is compared to buying insurance for your stocks. The cost of the put option is the insurance premium.
Low-Correlation Assets
A portfolio that is composed mostly of bank stocks and utilities is considered to be safe, while portfolios that consist mainly of gold and gold stocks are generally treated as risky.
On the other hand, buying a gold stock instead of other financial stock might in fact lower the risk of the portfolio as a whole. Gold and gold stocks usually have low correlation with interest-sensitive stocks and there are times when the correlations are even negative. Buying riskier assets that have very low correlation to each other is among the most effective diversification strategy.
Reducing Benchmark/Active Risk
Comparing a portfolio that has 100 percent US Treasury Bills and another that has 80 percent equity and 20 percent bonds, you would think that T-Bills are risk-free investments. On the flipside, an investor might have a long-term asset combination of 60 percent equity and 40 percent bonds as their benchmark.
If that’s the case, you may find that, compared to their benchmark, a portfolio that contains 80 percent equity will be less risky than one with 100 percent US T-Bills.