Carrigan: Be careful to manage your risk

Last Tuesday most of the major global stock indices tumbled in reaction to the downgrade of Greek bonds to junk status and the Goldman Sachs testimony before a U.S. Senate committee in Washington.

A few weeks ago I mused here that bear markets tend to frighten investors and bull markets tend to confuse investors. If bearish investors are to assume they are “fearful,” they should keep in mind that equity markets usually react only once to a crisis.

Now the Goldman fiasco may be a crisis for Goldman but it is not a crisis on the global stage. The Greek default issue is hardly a new surprise, given the county’s long history of default problems.

This leaves us with the bull market option of “confusion” because the equity markets have been advancing and investors still don’t “feel” that the financial crisis or U.S. housing bubble has been resolved.

For most long-term equity investors the best approach is to adopt a “crisis, what crisis?” attitude and learn to live with a constant state of confusion. In other words learn to live with some degree of investing discomfort. The best way to cope with investing discomfort is to adopt some common sense rules and restraints.

Here are a few things not to do.

Don’t time the market because for the most part the market advances at least 60 per cent of the time. The problem here is if you manage to sell out at a “top” there is a tendency to remain in cash too long and then miss out on the next bull market advance.

Don’t place a big bet on the “next big thing” or anything that is getting excessive hype in the business media. The next time you “get a hunch to buy a bunch,” take a deep breath and get a second opinion from an experienced adviser.

Here is what you can do.

You can be your own portfolio manager. As a portfolio manager you need only to adopt a few restraints and understand the terms Systematic Risk and Specific Risk

Some of the restraints would be to have some degree of diversification and limit your exposure to any single asset class or group of related securities. For example the ownership of five bank stocks, three life-co stocks and five energy stocks adds up to 13 positions but it also means you have placed a big bet on only two sectors, energy and financial. Keep in mind that some nasty corrections are sector related. We had the technology crash of 2000, the income trust crash of November 2006 and the banking crisis of 2008.

The term Specific Risk refers to the portfolio risk associated with a big bet on an individual security or related assets such as energy or technology stocks. Specific risk can be diversified away be limiting total exposure to any one stock to 10 per cent or any single asset class to 20 per cent.

The term Systematic Risk refers to the risk common to all securities in the portfolio such as the bull and bear cycles of the equity markets. As a rule Systematic Risk cannot be diversified away unless we use another tool of the portfolio manager - the short position or the non-correlated asset that will cushion any nasty corrections in the broader markets. The act of shorting stocks is for the most part not an option for most investors and so a better option is to seek out stocks or asset classes that generally operate inversely to the broader equity markets.

One stock group or asset class that will from tine to time operate inversely is precious metals. Lately the group has offered some downside protection but unfortunately during the 2008 financial crisis the gold stocks collapsed with all the other stock groups.

Our chart is the daily closes of the continual natural gas contract plotted above the continual crude oil contact. Their price relationship is unusual in that while both are energy-related they have been operating inversely. We also know that the price of crude and the direction of our own S&P/TSX Composite are highly correlated.

Now as my own portfolio manager I will now assume that if I insert some “gassy” energy stocks into my portfolio I have the best of both worlds – some down-side protection and the possibility of a bullish recovery in a depressed gassy sector.

Bill Carrigan, CIM, is an independent stock-market analyst.