The Finance Professor: Manage Risk Like a Pro

Now, how would you hedge your portfolio's risk?

The first step in answering that question is to determine how much risk is inherent in the portfolio. To do this, multiply the share position by price by beta for each stock and then add together the products.

With this portfolio, that would be:

CAT: 10,000 x 74 x 1.05 = $777,000

GOOG: 2,200 x 400 x 1.50 = $1,320,000

SO: 20,000 x 30 x .45 = $270,000

MW: 7,000 x 40 x .90 = $252,000

Total Risk: $2,619,000

Thus, you have risk of $2,619,000 relative to the S&P 500. If the SPX were to increase by 1%, your expected portfolio gain would be $26,190

If you were using bonds, you would have to look at the duration of the bond portfolio. Duration is a measure of risk for a bond that gauges the average maturity for the payment of all bond cash flows. Changes in interest rates will then impact the pricing of a bond based on its average duration.

What's important to note is that the longer the duration of a bond or portfolio, the more risk that bond or portfolio of bonds will carry. Thus, a 1% change in a bond portfolio with a three-year duration will have less impact on the portfolio than that of a seven-year duration portfolio.

Set Controls

Risk is managed by understanding the its impact on the portfolio. It is a game of targeting cause and effect. Let's not forget that without risk, there is no reward. So you have to go back to the basic question: How much am I willing to risk to achieve my desired return ? Once you have answered this question, you can use a stop order to manage the risk.