Don’t fear risk — hedge it

It’s the rare investor who is truly comfortable with risk – a recent Investor Education Fund survey found only one in 10 Canadians considers himself an aggressive investor.

But if you react to a market downturn by wondering where the buying opportunities are, there are lots of options for building a portfolio.

Several characteristics define investors capable of absorbing risk. As a rule, they:

• have liquidity and assets outside their portfolios;
• see opportunities during downturns;
• propose investments to their advisors;
• may have DIY or discount brokerage accounts; and
• don’t panic during times of volatility.

Investors seeking higher returns must be willing to consider non-traditional assets in order to achieve them. You should be comfortable with close to 100% equity in your portfolio, and be prepared to use private equity, hedge funds and small-cap stocks as diversification tools.

In the case of hedge funds and private equity, one portfolio manager notes the trick for retail investors is to get access at a reasonable price. “In Canada, your pickings are pretty slim,” he says. To compensate, he opts for international stocks instead, which historically are riskier (but often provide greater upside) than North American issues.

And, provided you can stomach the ride, cyclical sectors like mining and industrials can be appropriate. The returns can beat the market, but these investments have to be purchased at the right time to be profitable – and most investors, including professionals, find it difficult to time the market.

Why you still need low-risk assets

While long-term bonds might not seem exciting, especially since interest rates are low, no asset class should remain out of bounds. Higher-yielding corporate bonds can be suitable, and short-term bonds have their place in situations where you plan to access the cash soon.

Speaking of cash, one manager says it can make a good tactical reserve. A portion of the portfolio, for example 20%, could be in cash or short-term bonds, and you could use that money to buy equities or riskier bonds when those assets trade at discounts. Investment savings accounts, short-term GICs or money market accounts are usually better places for these funds than standard depository offerings, since you can pick up a bit of interest while waiting to deploy the cash.

Another option is keeping play money in a self-directed or discount brokerage account, especially if you have deep knowledge of a certain sector and want to try your hand at investments – especially if it’s something your advisor doesn’t offer. For portfolio balancing purposes, and to ensure the investments aren’t redundant or harm any hedging strategies, it’s important to discuss with your advisor how much you have invested and where.

You can also run your TFSA through a broker, since the maximum of $41,000 is a manageable amount for personal investing experiments.

Still, even if you’re comfortable with risk, any investments designed to fund your short-term needs should be on the conservative side. That’s because you need the money for a specific purpose – say, funding a business startup – and at a specific time. Such earmarked funds won’t be able to withstand a short-term correction of 15% or 20%.

Instead, keep those investments in short-to mid-term bonds or cash equivalents. And make sure the maturity dates for those investments match your time horizon.

Protect your riskier portfolio

A bold portfolio needs to be shielded from unnecessary losses. A sound tactic is to ensure the portfolio isn’t highly correlated with the bond or equities markets.

Having as much as a third allocated to alternative assets is one way to do this – preferably in market-neutral financial instruments and private equity, says one west-coast wealth manager. He notes Commodity Trading Advisors or managed futures ETFs aren’t correlated with most investments and help smooth volatility. And, he adds, he’s raised his cash position.

Currency hedging can also offer clients some protection. Keeping the portfolio geographically diverse can mitigate some currency risk. And since the U.S. dollar is rising against the CAD, exposure to non-hedged U.S. equity funds is a good option.