For the last two weeks, we’ve focused on understanding the differences between stock risk (here) and portfolio risk (here). We even have a short video for you that explains these concepts (here). Today we’re going to show you how to equalize the investment risks of different stocks in your portfolio in a way that may minimize your overall risk.
Last week, we took a broadly diversified portfolio that has seven stocks in seven sectors.
These seven stocks have a Portfolio Volatility Quotient (PVQ) of 12.04%.
We added Franco-Nevada (FNV) to the portfolio. FNV has a Volatility Quotient (VQ) of 31.2% which is much higher than any of the other stocks in the portfolio.
Because these stocks are so well-diversified, we were able to add a high-risk gold mining stock to the mix and actually lower the volatility of the entire portfolio. The new PVQ is now only 11.17%.
Now, there’s one last thing for us to do. We want to be sure that the risk we’re taking in each stock is equalized. This means we are going to take the same amount of dollar risk in each stock. For our new TradeStops members, this is a new concept. We call this “right-sizing” our portfolio.
To accomplish this, we will invest more money in our low risk stocks and less money in our high risk stocks. For instance, we are going to take the same amount of risk in FNV as we take in GE.
And according to TradeSmith, this is the single most important thing we can do to set up our portfolio for future success. Right-sizing our portfolio forces us to be disciplined and not put too much money in the stocks that have flashy stories. We’ve all probably had the experience of getting excited about a stock and putting a lot of money in it, only to see it move against us and causing large losses in our portfolios.
Here’s an example of what an individual investor could have done by following the TradeStops system and right-sizing their portfolio. The stocks that he owned were not changed.
Let’s take our well-diversified portfolio and right-size it. We use the Risk Rebalancer to do this. All we do is choose our portfolio and then click on the “Rebalance” button.
By right-sizing our stocks, we have actually lowered the volatility of the portfolio again. Now, the PVQ is only 10.78%.
What does this mean for our individual stocks? The right-sizing has equalized the risk in each stock. We are taking about 2% risk in each stock (that’s 2% of the portfolio value) which, in this case, equals about $970.
The Risk Rebalancer makes it easy for us by letting us know the actions we need to take.
Once you’ve rebalanced your portfolio, you probably don’t want to do so again for several months or more. We suggest that for most investors an annual rebalance is sufficient. Active investors might want to rebalance every six months.
The TradeStops tools are designed to give you the best opportunity to build and manage profitable investment portfolios. As TradeSmith has said “Successful investing is about staying in the game”. And equalizing your risk is a giant step towards being a successful investor.
Always judging risk,
Tom Meyer
Education Director
TradeStops.com
