top of page

How to Think About Portfolio Risk

When it comes to investing, managing risk is essential. However, most investors view risk only through the lens of volatility, or how much a portfolio fluctuates over time. While managing volatility is important, it's equally important to understand that temporary stock market losses do not necessarily mean a permanent loss of capital. It is important to distinguish the difference. As investors, we might be tempted to search only for the "holy grail" of investing: Generating consistently high returns with very limited downside losses at any given point in time. Wall Street hedge funds often pursue this type of strategy, which can be challenging, if not impossible, to achieve. The large institutions (and their billions of dollars) the hedge funds generally serve don't like volatility and are willing to pay a higher price to try and avoid it. These institutions may need to access a large chunk of their capital at any given moment, so lower volatility is often prioritized even when stocks are utilized. So instead of a "buy and hold" approach, many institutions prefer that their investments be managed with a very active trading style (usually computer-generated) and disregard for any tax liabilities the trading will cause. Hedge funds often will charge a management fee plus a 20% performance fee in exchange for promises of a low/volatility - high/return holy grail strategy. "A back-tested algorithm that has cracked the code!" If only there were such a thing.

Most retail investors aren't in a situation that requires a portfolio to avoid volatility at all costs. For example, you may be someone who is 10 years away from retirement, and higher volatility actually helps you buy stocks cheaper. Higher volatility is a good thing for you; it gave you the opportunity to buy NVDA at $113 a share six months ago when it is now trading at over $275 a share. Or maybe you are already retired and living off your dividends and interest, which get paid regularly even when volatility is high. Your income is still being paid, so your lifestyle is not affected. Portfolio volatility matters, of course, but you are better off focusing less on the daily swings of the stock market and concentrating more on the areas of your portfolio that you can control. And you can pay fewer taxes, less in fees, and have a reduced amount of correct trades to worry about.

At Ranch Capital, we emphasize three key areas of portfolio risk management: asset allocation, security selection, and position size.

Asset Allocation involves dividing your portfolio among different asset classes, such as stocks, bonds, and cash. The goal is to invest in a way that gives you the highest probability of achieving your long-term goals without significant disruption. Asset allocation can set the tone for how much your portfolio will fluctuate. You'll need higher stock exposure if you're aiming for higher returns. However, this also means accepting higher volatility. It's important to remember that growth and volatility are a packaged deal. If you only need an average return to meet your financial goals, you may not need as much stock exposure and should utilize more bonds. Our advice is to take as much risk as necessary to achieve your goals, no more or less. Determining the right mix of assets from the beginning of your portfolio construction will prepare you for times of uncertainty.

Security Selection involves researching and selecting the individual securities for your portfolio to invest in long-term. Once you've determined your asset allocation, you now want to select the types of stocks, bonds, various sectors, and specific companies that align with your investment objectives. For instance, an income-oriented investor would favor more dividend-paying stocks in their equity allocations than a growth-minded investor looking to retire in 15 years. Whether you should invest in individual companies or a diversified fund is another consideration. I like a combination, but prefer individual stocks, with the caveat that you must view them as a business rather than just a ticker symbol. There are literally thousands of investment options to choose from. My advice: keep it simple, buy companies you understand, keep your costs down, and avoid the trader nation mentality.

Position Size refers to the amount of money you invest in a single security, such as a stock, bond, or fund. Typically, we will invest anywhere between 2 to 10% in any one particular holding. We identify our highest convictions and give those holdings the most weighting in our portfolios. We also regularly review our holdings and adjust our position sizes as needed. We tend to trim or add to positions instead of trading in and out of positions. This helps when we want to hold a position long-term, but want to take advantage of a short-term price movement. The more upside potential you are shooting for, then the higher the concentration of positions you may want to own. For example, in Warren Buffet's fund, Berkshire Hathaway, just three stocks make up 60% of the portfolio. Conventional wisdom will say to avoid allocating too much of your portfolio to any one position. Still, I say go ahead with a 10% position if you are willing to accept the volatility that will accompany it.

In conclusion, effective risk management is critical to successful investing. But, instead of focusing solely on volatility, choose to focus on asset allocation, security selection, and position size. By implementing these strategies, you can worry less about market timing and help protect your investments and even increase your returns. Remember, investing is a long-term game, and having a well-thought-out risk management plan in place from the start can make all the difference.

God Bless, and Good Investing!

bottom of page