Assessing Risk and Taking Action

I recently received an email that raised an excellent question about how and when to reduce exposure and mitigate risk, albeit in a roundabout way. The reader asked what effect an unraveling of the carry trade would have on the Lazard Dividend & Income Fund (LOR - commentary - Cramer's Take), which I first wrote about last March.

Obviously, the question is about one aspect of a specific fund. However, it can be addressed more generally by examining how investors can recognize an escalation in risk and what course of action they should take once it's recognized.

An Honest Assessment

When managing your investments, you occasionally need to assess all of your holdings with an eye to what threatens the overall market and what might more narrowly threaten your portfolio.

In the Lazard case, the extreme weakness in the yen of late creates visibility for a correction to yen strength. Further, the Bank of Japan would not mind seeing an end to the perpetual sale of the yen to ease political pressure coming mostly from the European Central Bank.

There is no way to know, of course, if or when the yen will strengthen, but this is easy to follow, and it is also no secret that the carry trade is very popular these days.

As part of its investment strategy, LOR owns some currencies that benefit from the carry trade even if the fund itself is not engaged in it directly.

My advice to the reader was to look at his entire portfolio and try to assess how exposed his portfolio is to the carry trade. If he has 5% of his portfolio in LOR, 5% more in Australian assets (stock, bonds or currency), and another 5% in Magyar Telekom (MTA - commentary - Cramer's Take), which is the only Hungarian stock listed on the NYSE, chances are he would be hit hard in the wake of a big yen correction.

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At the time of publication, Nusbaum was long iShares MSCI Australia, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.