5 Basic Rules to Manage Risk in Your Portfolio

Greek debt crisis, euro value dropping, contagious risk, BP oil spill in Gulf of Mexico and the list of risk to the stock market go on continually. What will cause the value of your portfolio to decrease next?

These are some of the volatility issues that stockholders have to face on a daily basis. None of it seems to ever help your portfolio go up only down. Add to that the technical problems of a flash crash, faulty information or insider trading and you have things that are not inherent risk but manmade risk. How do you protect yourself against risk and manage your portfolio through the marketplace?

There needs to be an understanding that nothing is foolproof against all these risk factors but you can take measures that lessen the adverse impact on your portfolio.

First Invest in Dividend Paying Stocks

This is a tactic that you hear a lot about in the financial press but knowing why this works is beneficial. First of all if a stock pays a high dividend is that because it has dropped far and created what is called an accidental high yielder? Be very careful to investigate why the stock price dropped. Did they miss their earnings numbers and the market is punishing them or did they drop in an overall market plunge brought on by some cataclysmic news?

Next pull their financial statements to ascertain weather they can afford to maintain that dividend payment. Maybe they have high interest debt that is increasing on a percentage basis as their sales revenue is on a down word spiral due to economic conditions? Check their cash flow to make sure they have sufficient cash on hand to make payments without borrowing. Also I like to check how long they have paid continuous dividends.

Remember when you are holding stocks that are decreasing in value it is easier to remain calm knowing you will receive a dividend payment every three months to offset some of those losses.

Second is to Rebalance the Asset Allocation of Your Portfolio

When you have continued volatility and market risk the allocation of your monies gets skewed to the point that there is a need to bring your portfolio back into balance with your investment objectives. A well balanced portfolio has cash, stock, bonds and short-term assets. Asset allocation is a basis of risk management and will help your portfolio to stay less volatile in an otherwise wildly gyrating market.

Third is to Make Sure that Diversification is Maintained

Makes no difference that diversification includes sectors as well as countries and regions. Big portfolio managers in hedge funds, mutual funds or corporate investment roll from sector to sector as the profits seem to change during the year and economic conditions gyrate.

For instance when the market is recovering from a recession and work is ramping up portfolio managers tend to sell technical or retail sectors and roll the money to industrial or machinery sectors as manufacturing starts to ramp up. If all your funds are in technical or retail stocks your portfolio could take a strong hit. But if you are invested in machinery as well as retail your portfolio maintains itself without serious downside risk.

Also add an international flavor to your portfolio so when European stocks are down Chinese stocks are growing exponentially to help offset losses and gains.

Fourth is to Only Purchase on Dips in the S&P

If you maintain purchasing only after a dip of three percent or more and ladder your purchases as it goes down you will create a downward average in your cost basis making your portfolio self balancing when the market jumps three percent or more on the upside. This is a tactic that every hedge fund or large portfolio manager uses to insure that they get a reasonable cost basis. No one can predict tops or bottoms consistently.

As a bonus you should always sell on a ladder basis as the market is increasing the value of your stocks. Remember no one ever went broke taking a profit and what goes up in the stock market also tends to go down.

Fifth Rule of Managing Risk is Having Cash on Hand

Most large portfolio managers will tell you they maintain 10% of their portfolio in cash. I think in times of high volatility such as we have experienced lately that should be increased to a 20-25% position. Then when the market stabilizes you can take advantage of low pricing to setup gains down the road.

Well that's the five basic rules to managing risk in the marketplace and keeping your portfolio from experiencing additional losses.