How do you reduce risk in your portfolio?

When it comes to investing, we frequently get involved in complex debates on global economics, what the current "hot" sectors are, and in recent years, the status of the Canadian dollar. These discussions are primarily based on reports from the media, who tend to focus on how short-term events affect our investing. However, they spend little time on how and why we invest in the first place.

Why do we invest? Most people save their hard-earned money because they have a dream, whether it is retirement, children's education, a cottage or world travel. The prudent management of your portfolio should revolve around this dream, not around keeping up with the Joneses.

How do you invest effectively?

To keep your portfolio on track, you should to adopt a consistent strategy and adhere to it through thick and thin. The Efficient Frontier is one such investment strategy. This approach is based on an investing theory of risk-efficient portfolios associated with Nobel laureates Harry Markowitz and Bill Sharpe. They maintain that the goal of investing is to minimize your risk for the amount of return you wish to achieve, through the diversification of your portfolio by asset class, geographic allocation and style of investment management.

The Efficient Frontier is illustrated in the following graph:

When investing capital, all other things being equal, you should seek to minimize volatility in your portfolio.

In order to determine whether or not a portfolio falls on the Efficient Frontier, you must consider three factors for each asset in your portfolio:

1. Estimated rate of return, or what your money will earn when it is invested.
2. Level of risk. "Risk" measures the likelihood that your investment will do better or worse than the expected rate. The greater the volatility of an asset, or the chance that it can earn much higher or lower returns than expected, the more risky the investment.
3. Correlation to the other assets in the portfolio. In other words, the assets should not be too similar so that your entire portfolio is not affected when one sector of the market dips.

A rebalancing act

Once you have found a portfolio along the Efficient Frontier that offers an expected rate of return for your assumed degree of risk, you still have to ensure that your portfolio remains efficient during swings in the economy. This task is known as rebalancing.

If your portfolio moves away from its original asset, geographic or investment style allocation, you may find that your exposure to risk could increase beyond your comfort level, or your future growth potential could decrease and negatively affect your investment goal. By rebalancing your portfolio on a regular basis, you make sure that it is moving with the market, yet the asset classes remain fixed in how they relate to one another. You can effectively rebalance your portfolio in one of these ways:

• Sell any holdings that are over your target asset allocation percentages and reinvest the money in other assets.
• Increase the total dollar amount you have invested and buy more of the investments that are below your target asset allocation percentages.
• Direct dividends away from the investments over your asset allocation percentages and into the ones that have dropped below your target percentages.

Obviously, each method of rebalancing has its own set of consequences. You should evaluate how each could affect your investment goals and then decide accordingly.

How can I manage this?

By now, you're probably saying, "But I already have a full time job. How can I possibly take on the task of managing a portfolio to maintain its efficiency?"

The answer is: You are usually on your own. Statistics show that 96 percent of us never rebalance our investments. Our team can help develop not only portfolios that are strategically placed along the Efficient Frontier, but also a system to automatically rebalance them for you. If you would like to explore how this service can benefit you, do not hesitate to call our office for a consultation.