5 Tips on Managing Risk in Your Portfolio

Editors' pick: Originally published Nov. 18.

"This can't be happening."

That has become the catchphrase of 2016.  From Donald Trump becoming President-elect to Brexit to the Syrian crisis to Zika, 2016 has seen more than its fair share of global turmoil.

Many of these can be considered black swan events -- events that investors don't expect and that deviate from what is expected. Most are random and difficult to predict, making it extremely that important portfolios are protected against the unexpected.

"If an investor spreads their assets around in less correlated assets and have enough exposure to assets that are low in risk -- i.e. shorter duration bonds, cash, or other alternative investments -- it can help," said Rob Lutts, CIO of Cabot Wealth Management. "A healthy spread among those assets reduces risk substantially."

Turmoil can impact investors in different ways, from loss of capital or impacting the potential upside in a trade. It's important to remember that diversification is not a dirty word on Wall Street, Lutts said. It helps provide exposure to different assets and allows you not to be too heavily weighted toward one sector or one asset class, like stocks or bonds.

With so many unknowns in the investing world, it's important to manage risk, limiting downside, while protecting upside. These tips can help.

1. Market/asset class risk

Sure, a lot of investors think stocks in different sectors are correlated, meaning they trade up or down together, but it's important to remember different asset classes trade together as well.

"The one thing many people miss is they don't understand correlation between different asset classes," Lutts said. In order to get away from highly-correlated assets, it's important to have different levels of risk in portfolios.

Assets like high-quality shorter-duration bonds, fixed income and alternative investments like gold and precious metals can help keep risk profiles at a minimum.

"I think gold is one of [the better performing assets] today," Lutts said. "A lot of people think gold should be buy and hold, but it needs to be looked at in cycles. We've had a five-year correction from $1,900 to $1,100, now we're accelerating again. If you're looking to protect your portfolios, an allocation to gold and precious metals makes sense."

2. Follow the rich

Donald Trump has made his fortunes in real estate, as has Wang Jianlin, Lee Shau Kee, Michael Otto and a host of others.

Real estate has been a great builder of wealth, so it's important to look at it more than just a place to live.

"One asset class to consider is real estate and land," Lutts said. "We have a high net worth clientele who have assets in many different classes, but real estate is a big one. They own land or something else related to real estate. Good real estate will be correlated to economy and if it's in good location, it's a good wealth builder."

Farmland, crowdfunding and other hidden gems can provide investors with real estate exposure in their portfolios that have traditionally performed well over time.

3. Size matters

It's important not to let positions in a portfolio get too big, otherwise investors could be subject to the whipsaws of that particular stock more than they want.

"If you invested in a company 20 years ago like Apple (AAPL) , a lot of folks let it grow and become large part of portfolio, with some letting half of their money be in one stock," Lutts said. "You want to limit the risk you have in any stock, so put 5% of your portfolio in any one stock. If it grows to slightly more than 6%, it can always be pared back to 4 or 4.5% -- you're reducing risk that that one stock influences the portfolio."

This can be difficult when you're investing in high-growth companies like in the technology sector that are riskier than others, so it's important to pay attention to your assets.

"We like Tesla (TSLA) and there are many companies that can grow, 25%, 50% or 60% a year," Lutts added. "In order to invest in these kinds of stocks, you have to have a loss limit -- ours is at 20%. If we're wrong in timing and it's the wrong stock, we don't have too much capital invested and we have discipline."

4. Do your homework

Just like when you were a kid, homework will help you get ahead.

It's important for investors to do their own homework and not rely on others. This includes understanding the investment, doing fundamental research (going to stores, seeing how products are selling), looking at the competition or listening to what management has to say.

"If you do that properly, you put yourself in a better position and can manage risk that way," Lutts said. 

Understanding and keeping an eye on companies that are changing how their industries operate can be a way to get outsized investment returns.

"Think about Walmart (WMT) when it first started out -- did anyone think Walmart would be the world's largest retailer with $400 billion in revenues and creating hundreds of billions in wealth?" Lutts said. "It's important to be open to success." 

Conversely, it's also important to be open that things may not always work out the way they were intended.

Tesla has become the leader in electric vehicles, but Henrik Fisker and Fisker Automotive were going head-to-head with Elon Musk's company several years ago. Ultimately, Tesla prevailed, while Fisker filed for bankruptcy, ultimately being sold to the Chinese.

5. Buy the best

We are at an inflection point in society, where technological innovation is exploding and people are excited and concerned at the same time.

Areas like machine learning, autonomous driving, artificial intelligence and the like are bound to have profound impacts on society, most of them positive. However, there's a real concern that these technologies will take away considerable amounts of jobs, so it's important to be aware of major changes going on in the economy, Lutts said.

"You want to buy companies that are leading in those sectors," he said. "Companies like Google (GOOG) (GOOGL) , Facebook (FB) and Amazon (AMZN) are leading here. Most of these stocks haven't priced in a stream of income or revenue from new products just yet."

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